How to Invest in Marijuana ETFs

Investors can gain exposure to the cannabis industry by adding marijuana exchange-traded funds to their portfolio, as a growing number of them began trading in 2019.

The burgeoning market has hit several roadblocks, as some companies like MedMen (ticker: MMEN) burned through cash and ousted its founders earlier this year, while CannTrust Holdings filed for bankruptcy protection after it was found growing cannabis illegally.

The higher volatility that occurs in marijuana stocks makes them a riskier asset, and many investors turn to marijuana ETFs to gain exposure to the nascent sector and lower the amount of risk.

Several marijuana ETFs were approved by the U.S. Securities and Exchange Commission in 2019.

The AdvisorShares Pure Cannabis ETF ( YOLO) began trading on the NYSE Arca in April 2019 and charges an expense ratio of 0.74%. This ETF provides a generous dividend yield of 7.26% and is actively managed with $45 million in assets. The ETF tracks Canadian and U.S. companies that are in the consumer products, health care and real estate industries. The top three holdings are Innovative Industrial Properties ( IIPR) at 9.5%, Village Farms International ( VFF) at 8.4% and GW Pharmaceuticals ( GWPH) at 7.9%.

The first U.S.-focused marijuana ETF, the Horizons US Marijuana Index ETF (HMUS), began trading in April 2019 in Canada with an expense ratio of 0.85%. The ETF holds 30 U.S. companies and owns 11.4% in Green Thumb Industries (GTIBF), 11.4% in Curaleaf Holdings (CURLF) and 10.7% in Trulieve Cannabis Corp. (TCNNF).

[Read: What Is an ETF? The Ultimate Guide.]

The Cannabis ETF ( THCX) began trading in July 2019 and owns 30 stocks with an expense ratio of 0.7%. The ETF is passively managed and tracks the Innovation Labs Cannabis Index. The ETF only has $20.7 million in assets but provides a dividend yield of 4.1%. The top three holdings are Aphria ( APHA) at 7.9%, Cronos Group ( CRON) at 6.9% and GW Pharmaceuticals at 6.4%.

Investors have increasingly turned to passively managed ETFs in all sectors because of the low fees and higher returns than actively managed ones. In 2019, passively managed funds reported net inflows of $162.7 billion, while actively managed stock funds reported net withdrawals of $204.1 billion, according to Morningstar.

Actively Managed ETFs Are Less Risky

Investing in passively managed ETFs in the cannabis industry can lead to problems, says Jason Spatafora, co-founder of and head trader at Portfolio managers in actively managed ETFs have more control because they can divest companies at the first sign of a major problem, such as when Canadian regulators discovered that CannTrust Holdings was growing cannabis illegally, he says.

In passive ETFs, holdings in cannabis companies are only rebalanced quarterly.

Instead of adding a cannabis ETF to a portfolio, Spatafora, who publicly exited cannabis stocks in March 2019 and went short, recommends that investors create their own “index” with fewer companies since many of these funds are “holding a lot of garbage,” he says. “You want to be in companies that haven’t seen their all-time highs, have legislative catalysts to grow on and Canadian cannabis companies have too much risk right now. Investors are better served finding value on their own rather than buying them in an ETF holding a few gems, but mainly junk.”

The volatility in the sector during the past year has impacted the returns of stocks, says Michael Berger, founder of Technical420, a Miami-based company that conducts research on cannabis stocks.

“An actively managed ETF is a better strategy for this current market environment,” he says.

[See: Best Low-Cost Energy ETFs to Buy Now.]

Investing Strategies in Cannabis ETFs

Investing in cannabis ETFs right now can be risky because volume in marijuana stocks decreases historically during the summer, Spatafora says.

“Now is not the time to invest in them,” he says. “It’s better to invest in them closer to August. There is still some downside right now. You can get a better price by being patient, and I’m forecasting an end to the bear cycle by fall.”

Another major factor against investment in cannabis ETFs is that the SEC prohibits ETF providers from owning shares of companies that directly touch the marijuana plant because it remains a Schedule I controlled substance, even though many states have approved both the medicinal and recreational use of cannabis. Many cannabis ETFs cannot hold shares of U.S. marijuana companies.

“You’re largely not going to have U.S. cannabis companies in ETFs because U.S. exchanges won’t list them because of the federal restrictions,” says Timothy Seymour, founder of Seymour Asset Management in New York and portfolio manager of Amplify Seymour Cannabis ETF ( CNBS), whose top three holdings are GW Pharmaceutical at 12.85%, Canopy Growth Corp. ( CGC) at 11.3% and Cronos Group at 8.2%.

The regulatory environment will likely change since the U.S. cannabis market is the largest in the world, he says.

“Ultimately, the U.S. will come up with legislation and some relaxing of regulatory rules as companies seek access to banking and the capital markets,” Seymour says.

The cannabis market is a “great consumption story because it is a very sophisticated consumer product with retail distribution that is over the top,” he adds. “The quality of companies that have stepped ahead of others and people working in the industry has come a long way. The level of sophistication and operational excellence is very different than what it was three to five years ago.”

The majority of cannabis ETFs own shares of Canadian companies that have already seen their all-time highs, Spatafora says.

The Cannabis ETF could be a good addition for investors, he says. While ETFMG Alternative Harvest ETF ( MJ) has $581million in assets and a generous dividend yield of 7.25%, the passively managed ETF holds large positions of 10.7% in GW Pharmaceuticals, 9% in Cronos Group and 7.97% in Canopy Growth Corp. MJ does allow investors to buy calls and puts and short the ETF.

[Read: 7 Best Sector Funds to Buy for a Recession.]

Investors should trade the stocks of Canadian cannabis companies instead of holding them as a longer-term investment, Spatafora says. The Canadian company Canopy was downgraded by analysts after taking charges during the fourth quarter and is now trading at about $16 a share, losing more than half of its shareholder value from a high of $49.91 in 2019.

U.S. marijuana companies have the potential for more growth because there is a larger customer base, but until more ETFs can add them, investors should be wary of investing in the current lineup of ETFs.

“Why do you want to be in an ETF forced to hold some of that junk when the U.S. market is way bigger than the Canadian market?” Spatafora says. “The state of Colorado did more in cannabis revenue in 2019 than the whole country of Canada. The growth is simply where the population is, and the United States is a target-rich consumer environment.”

Canada faces a large number of challenges since its marketplace does not have enough dispensaries open to customers compared with the volume of cannabis grown there.

“Canada has a lot of hurdles before they can really hit those numbers they were targeting in 2017-2018 when everyone was building giant grow houses based on ‘funded capacity,'” he says. “Another big issue these companies face is a serious lack of dispensaries to sell product in and more write-downs for acquisitions they overpaid for.”

Unlike U.S. companies such as Green Thumb, Trulieve and Curaleaf that are “putting up exceptional numbers and positive EBITDAs, the Canadian companies are nowhere near that,” Spatafora says.

The cannabis market is growing since many states considered marijuana businesses essential during the pandemic. By 2025, the industry will grow to $33.9 billion with a compound annual growth rate of 18.2%, according to a recent report by The Arcview Group, a San Francisco-based cannabis investment and research firm.

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