Marijuana ETF Shifts Custody

September 18, 2018

ETF Managers Group, issuer of the ETFMG Alternative Harvest ETF (MJ), the market's only pure-play marijuana fund, has replaced the fund's custodian, U.S. Bank, effective yesterday, Sept. 17.

According to an update to MJ's Statement of Additional Information (SAI), the new custodian for MJ is Wedbush Securities, a broker-dealer based in Los Angeles.

In addition, ETFMG will now take the fund's administrator duties in-house. Transfer agent services, meanwhile, will be handled by Canton, Massachusetts-based Computershare Trust Company.

Formerly, the administrator and transfer agent roles were performed by U.S. Bancorp, parent company of U.S. Bank.

ETF.com has contacted ETFMG for comment without response.

No Rationale Given

No rationale was given in the SAI update as to why ETFMG and U.S. Bank decided to part ways, but the likeliest explanation has to do with ongoing risks of acting as custodian for the ETF.

For months, questions have swirled about whether U.S. Bank, a federally chartered and licensed bank, would be willing to continue shouldering the potential legal risk of being a custodian of a marijuana ETF.

For a while it seemed that no news was good news, and that the custodian issue may have been quietly resolved. That appears now to not be the case.

U.S. Bank declined to comment for this article.

What Is A Custodian?

A custodian plays a vital, but often-overlooked, role for any ETF by holding securities on behalf of the fund.

As ETF.com has extensively reported, until recently, most big U.S. banks have refused to be a custodian for a marijuana ETF. That's because holding stocks involved with a drug still outlawed by the U.S government could potentially run a bank afoul of a Dept. of Justice newly recommitted to prosecuting federal marijuana-related crimes (read: "Promise & Peril Of Marijuana ETFs").

It's not that the underlying marijuana stocks themselves are verboten, since many custodians already hold these for other contexts. For example, Canopy Growth Corp., a Canadian medical marijuana producer, is both the largest holding in MJ and the second-largest holding in the nonmarijuana-related SPDR S&P International Small Cap ETF (GWX).

Instead, the problem is that custodian banks would be holding these stocks specifically for a marijuana ETF. When a federally chartered, licensed and insured bank declares that the primary reason it is holding marijuana companies is to provide exposure to a federally illegal substance, the bank invites additional scrutiny; it runs the risk of being denied FDIC insurance or even losing its banking license.

That's true even though the majority of investable marijuana stocks are domiciled in Canada, where marijuana is legal. Though those stocks may fall outside U.S. jurisdiction, the custodian bank does not.

ETFMG Circumvents US Bank

The custodian issue was brought to the forefront through the unusual way in which ETFMG brought MJ to launch.

Instead of the usual filing-to-launch process, ETFMG retrofitted one of its existing ETFs with a new index. Prior to Dec. 26, 2017, MJ tracked Latin America real estate and carried the ticker "LARE" (read: "When An ETF Changes Its Exposure").

In so doing, ETMFG circumvented the need to find a new custodian for the fund or get the SEC's green light for a de novo ETF. Despite the dramatic difference in indexes between LARE and MJ, the ETF had already been approved once and would not need to be reapproved. In fact, ETMFG didn't even need to get input from LARE's custodian, U.S. Bank, before making the change.

Prior to MJ's index switch, U.S. Bank had demonstrated little appetite for a marijuana ETF, turning down multiple proposals similar to the fund from other issuers.

Justice Dept. Pressures Federal Banks

Although medical marijuana has already been legalized in 31 states, and recreational marijuana is now legal in nine, as well as the District of Columbia, marijuana itself remains illegal at the federal level, classified as a Schedule I substance alongside heroin and ecstasy.

U.S. federal banking laws prohibit the production and sale of marijuana, classifying any pot-related financial transaction as money laundering.

In recent weeks, the Trump administration has significantly stepped up its efforts to renew the so-called war on weed.

In August, BuzzFeed News reported that the White House had amassed a cross-agency task force to combat public support for legalization, while Politico reported last week that Canadian citizens who worked at or invested in marijuana companies risked lifetime bans on travel to the U.S.—even if those companies were legally trading in the U.S.

About MJ's New Custodian

Wedbush Securities, one of the largest investment banks in the western U.S., is a member of all major securities exchanges as well as the Depository Trust & Clearing Corporation and the National Securities Clearing Corporation. Wedbush also currently serves as authorized participant for a number of ETFs.

Yet Wedbush Securities is much smaller than U.S. Bank, with $1.6 billion in assets under management, according to its most recently filed ADV. (U.S. Bank has roughly $456 billion in assets under management.)

Furthermore, Wedbush Securities is also a privately held company, meaning it does not have to meet the same federal regulatory guidelines as publicly traded companies. It is, of course, still subject to federal banking law and holds FDIC insurance.

Wedbush Securities is no stranger to cutting-edge financial services. In 2014, it became the first U.S. financial institution to accept payments tendered in bitcoin.

Wedbush Securities declined to comment for this article.

ETFMG Makes Other Changes To MJ

In the SAI update, ETFMG also announced it was itself taking on the role of administrator for MJ (ETFMG already serves as the fund's investment advisor).

The administrator of an ETF handles regulatory reporting, investor record-keeping and other shareholder services. As such, it works closely with companies' investor relations departments to satisfy a variety of investor needs.

According to the SAI, ETFMG has put down a firewall between its activities as investment advisor and its activities as administrator, absolving the first from any liability from "any error of judgment or mistake of law or for any loss suffered by the Trust" committed by the second, except in the case of "willful misfeasance, bad faith or gross negligence" by the advisor.

As administrator of its own fund, ETFMG will be entitled to a fee based on the average daily net assets of MJ, as well as some unspecified minimum annual fee. This expense will come out of the investment advisory fee, meaning it likely will result in no new costs to MJ investors.

MJ Growing In Popularity

MJ has seen an influx of cash since mid-August, on the back of several high-profile deals and partnerships between marijuana companies and large, publicly traded beverage makers. As a result, MJ's recent performance has been off the charts; currently its 30-day return is 42% (read: "Marijuana ETF Top Aug. Performer").

Since Aug. 20, MJ has taken in $104 million in new net investment assets. That's a considerable sum, considering the fund had seen just $17 million in inflows in the six months prior:

 

Sources: ETF.com, FactSet; data as of Sept. 17, 2018

 

Currently MJ holds $578 million in assets under management, according to issuer data.

Only time will tell whether MJ's new custodian resolves the fund's custodial risk once and for all, thus bringing on even more investors from the sidelines.

Contact Lara Crigger at [email protected]

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