Launching an ETF isn't easy, even for vanilla, large cap core products. There's regulatory paperwork, back-and-forth with the SEC, listings requirements—not to mention lining up market makers and initial seed capital.
For funds offering exposure to cannabis stocks—a market that's still technically illegal at the federal level—issuers must fight even harder to get their products launched. Launch delays have become common for marijuana ETFs, caused by everything from intensifying SEC scrutiny to persistent reluctance among the capital markets community.
These issues could spell problems for nascent marijuana ETFs long past launch, even though the regulatory climate is becoming more favorable.
More Marijuana ETFs On The Way
These six ETFs are listed below:
|Marijuana ETFs, Launched & Prospective|
|MJ||ETFMG Alternative Harvest ETF||ETFMG||12/26/2017|
|YOLO||AdvisorShares Pure Cannabis ETF||AdvisorShares||4/17/2019|
|THCX||The Cannabis ETF||Innovation Shares||7/9/2019|
|CNBS||Amplify Seymour Cannabis ETF||Amplify||7/23/2019|
|TOKE||Cambria Cannabis ETF||Cambria||7/25/2019|
|N/A||Global X Marijuana ETF||Global X||Future|
Sources: ETF.com, issuers; data as of July 22, 2019
For issuers, the good news is that the custodial risk that has plagued cannabis ETFs for years appears to finally be lifting.
Until very recently, many large national banks were unwilling to hold cannabis stocks specifically for a cannabis ETF, out of fear that doing so could run them afoul of federal banking law.
In fact, the ETFMG Alternative Harvest ETF (MJ) and its former custodian, U.S. Bank, parted ways over just this issue; MJ's issuer has since signed Wedbush Securities, a regional broker-dealer, as its custodian instead (read: "Marijuana ETF Shifts Custody").
Political Tides Shift
Politically, however, the tide appears to be shifting toward greater legalization. Two-thirds of states have adopted some measure of marijuana legalization within their borders, while 11 states have legalized it for full adult recreational use.
Even Congress has begun debating how—not if—to move forward on legalizing marijuana at the federal level (read: "Congress Rethinking Marijuana; ETFs May Benefit").
As a result, banks that were once reticent to custody marijuana stocks have changed their tune. For example, the Bank of New York Mellon serves as custodian for the AdvisorShares Pure Cannabis ETF (YOLO), while Brown Brothers Harriman will custody the Cambria Cannabis ETF (TOKE).
Difficulties In Securing Seed Capital
However, even as custodian banks become more welcoming to marijuana products, other ETF servicers have begun to express reservations.
On July 5, the Amplify Seymour Cannabis ETF (CNBS) went effective, meaning the fund vehicle itself was ready to be populated with stocks and accept investment assets. However, the fund didn't officially begin trading until today, July 23.
The delay resulted from difficulties in lining up seed capital, says Amplify's CEO Christian Magoon: "We talked to more parties than normal about obtaining seed."
Many potential seed partners had "reputation concerns," he added. Often, broker-dealers place restrictions on the types of stocks that advisors can own for their clients, including marijuana stocks.
Magoon says that means that "a lot of the market-making community was concerned that if they were seeding or acting as lead market maker for a cannabis ETF, that it might potentially cause them some business relationship problems with the brokerage community."
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.
Contact Lara Crigger at firstname.lastname@example.org