Proposed Marijuana ETFs Rooted Differently

February 26, 2019

Pure-Play Dilution

Though MJ is often billed as a pure-play, its inclusion of forward-looking tobacco plays and ancillary support industries somewhat dilutes its exposure.

Tobacco-related companies represent 22% of MJ's portfolio, while Scotts Miracle-Gro (SMG) and Turning Point Brands (TPB) represent another 2% each. (Although alcohol companies dabbling in cannabinoid/THC-related products are not specifically called out in MJ's prospectus, they do and have appeared in the fund's portfolio in the past.)

That leaves an opportunity for competitors to offer a purer-play investment on the marijuana sector.

Furthermore, it's worth noting that, over the past year, MJ has run into issues with its service providers, including its original custodian, U.S. Bank, which was reluctant to custody stocks associated with a federally illegal substance.

In September, ETFMG parted ways with U.S. Bank and signed Wedbush Securities, a regional broker-dealer, to act as its custodian instead (read: "Marijuana ETF Shifts Custody").

Using Derivatives To Access Marijuana Stocks

Starting last year, a slew of new marijuana ETF proposals were filed. Last November, Innovation Shares filed for its Innovation Shares Cannabis ETF, while in January, AdvisorShares filed for the AdvisorShares Pure Cannabis ETF.

Then, earlier this month, Amplify ETFs filed for the Amplify Seymour Alternative Plant Economy ETF (read: "Competition Heats Up In Marijuana ETFs").

Of the three, perhaps the most different from MJ is AdvisorShares' proposed fund, which would use primarily swaps, futures and other derivatives to gain access to both U.S.- and foreign-listed cannabis equities and cannabis indexes.

This means that, for the most part, the marijuana stocks that large U.S. banks are so loath to hold wouldn't technically be part of the fund portfolio; the ETF would hold derivatives of those stocks instead. (The fund may also hold some stocks, though presumably not the ones a custodian bank would object to holding.)

While potentially solving the custodial risk issue, banks' use of derivative instruments is widespread and commonplace—using derivatives in place of stocks could introduce myriad other trading and market risks.

Active Management Casts Wide Net

As an actively managed fund, AdvisorShares would have wide leeway in what criteria to use in building its portfolio, including third-party analyst ratings and stock selection tools, as well as the firm's own discretion on overlooked and undervalued stocks.

The fund managers also reserve the right to participate in initial public offerings, an unusual step that could widen their investment scope and potentially provide an edge.

To be eligible for inclusion in the fund, though, constituents would need to derive at least 50% of their net revenue from the legal marijuana and hemp industry; or be registered with the Drug Enforcement Agency specifically to engage in cannabinoid-related medical R&D.

At least 25% of the fund's portfolio would be concentrated in pharma, biotech and life sciences firms researching cannabis-based medicines.

And, of course, the stock would need to be legal. "The Fund will only invest in companies that engage in cannabis-related business that is permitted by national and local laws of the relevant jurisdiction," said the prospectus.

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