Legal Opinions Now Required
CNBS had already been delayed to launch by a month due to the SEC's new requirement that all existing and would-be cannabis ETF issuers must submit a third-party legal opinion regarding the legality of their potential holdings.
The legal filing cost about $30,000 to obtain, estimates Magoon, and must be recertified every year.
"Our counsel told us they'd never heard of something like this before, where you had to get a third-party legal opinion to launch a fund," he said.
AdvisorShares also had to obtain a third-party legal opinion before it could launch YOLO; additionally, the firm had to submit to its custodian and its listing exchange a list of securities in which the actively managed ETF would potentially invest.
Use Of Swaps Raising Questions
Not included in that list of securities were the individual swaps contracts that YOLO now uses to obtain exposure to certain multistate operators (MSOs).
Many MSOs engage in the cultivation, production or distribution of marijuana and marijuana-derived products inside the U.S., which is still prohibited under federal law. Therefore, these companies don't meet the listings standards for most U.S. exchanges; for example, they can't be listed on the NYSE.
YOLO, which is traded on the NYSE, uses swaps to obtain exposure to MSOs. This use of derivatives to obtain MSO exposure is entirely legal; and AdvisorShares stated in its regulatory filings and prospectus that it planned to use derivatives as part of its active management strategy.
Transparent From Day 1 On Swaps
“It's been very transparent and clear from day one what we were doing," said Dan Ahrens, COO of AdvisorShares and portfolio manager for YOLO.
However, sources confirm that the NYSE and SEC were surprised to learn YOLO was using swaps to achieve exposure to MSO, and legal counsel for both parties has taken the issue under additional review.
The NYSE indicates in its generic listings standards that an actively managed ETF may have no more than 20% of its portfolio in over-the-counter swaps contracts and other derivatives. YOLO currently has 12% of its portfolio weight in swaps, not all of which are MSO-related. (It uses swaps to obtain exposure to U.K.-based GW Pharmaceuticals.)
Other marijuana ETFs on the market, which are index-based and subject to different listing requirements, do not use swaps contracts in the same manner. Magoon confirmed that though CNBS is actively managed, the fund has no current plans to implement swaps of MSOs, citing concerns about legal enforcement actions, such as fines or stop orders.
Reluctance Could Mean Trading Problems
Though all the new marijuana ETFs eventually did find the seed capital needed to launch, reluctance on the part of the capital markets desks to support marijuana ETFs is a worrying sign for those products—and their investors.
Without sufficient market makers and authorized participants (APs), it is difficult for ETFs to achieve sufficient liquidity; spreads tend to widen, and premiums/discounts to net asset value can develop and persist.
MJ in particular has struggled in the past attract a large base of APs, which has hurt its ability to minimize spreads (read: "Large, Liquid ETFs With High Spreads").
Currently, MJ's average spread is 0.25%, which is substantial for a fund with more than $1 billion in assets under management.
Ahrens says that while AdvisorShares had no trouble lining up APs for YOLO, the firm had a "heightened level of communication" with APs and market makers.
"With this fund, we had a lot of explaining to do about what we would and would not invest in," he added.
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