Proposed Marijuana ETFs Rooted Differently

February 26, 2019

Finding investable companies in the marijuana industry isn't easy. For starters, there's the legalization issue: Cannabis remains classified as a Schedule I substance, making it difficult for U.S.-based marijuana firms—including growers, retailers and R&D firms—to secure listing on U.S. exchanges.

Then there's the sector's volatility. Marijuana is a rapidly evolving sector, with the individual players and capitalizations changing significantly from year to year, even month to month. Micro caps, reverse takeovers and pink sheets abound, and the handful of well-capitalized, pure-play cannabis companies that do exist often whipsaw monthly in price.

 

Source: StockCharts.com; data as of Feb. 25, 2019

 

With such a small investable universe, you might expect the portfolios for the three newly proposed marijuana ETFs to be pretty much carbon copies of the sole existing pure-play on the market, the $1 billion ETFMG Alternative Harvest ETF (MJ) (read: "Competition Heats Up In Marijuana ETFs"). But you'd be wrong.

Each of the three funds proposes a unique mousetrap, ensuring that if and when they come to launch, we wouldn't be looking at a slew of me-too products just trying to recapture MJ's lightning in a bottle.

A Peek Under MJ's Hood

Currently, MJ is the only pure-play marijuana ETF on the market, though the $14 million AdvisorShares Vice ETF (ACT) has 37% of its portfolio in cannabis-related and cannabis-adjacent stocks.

As an index-based fund, MJ tracks U.S. and global companies involved in one of four main lines of industry:

  • The legal cultivation, production, marketing or distribution of cannabis (including industrial hemp). To qualify, companies must derive at least half their revenues from cannabis activity.
  • The creation, marketing or distribution of prescription-based cannabinoid drugs (as opposed to the "medical marijuana" business, which uses the cannabis leaf rather than compounds and extracts from the plant itself).
  • Tobacco companies, including cigarette and cigar component makers.
  • Companies that produce fertilizers, pesticides and growing equipment for cultivation.

In addition, MJ implements size and liquidity screens to eliminate stocks with a market cap of less than $200 million and a three-month average daily trading volume lower than $500,000.

 

For a larger view, please click on the image above.

Source: ETF.com; data as of Feb. 25, 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.

Amplify Enlists Expert Portfolio Manager

Amplify's proposed ETF would also be actively managed. However, rather than relying on in-house expertise, Amplify lists Tim Seymour, CNBC host and marijuana investing expert, as the fund's portfolio manager.

Seymour will base portfolio decisions on public regulatory filings, third-party research and other public data, as well as his own evaluations of the companies' financial fundamentals, taking into consideration everything from macroeconomic trends to environmental, social and governance scores.

Of the three filings, Amplify's proposal delineates the clearest rules about what kinds of global companies the funds can and cannot invest in, breaking eligible constituents into three categories:

  • Cannabis/Hemp Plant (including pharmaceutical and biotechnology firms, cultivation and retail, and firms involved in hemp and cannabis-infused products)
  • Support firms (including agricultural technology, real estate and commercial services)
  • Ancillary companies (including consumption devices, investing and finance, technology, media and other companies)

Amplify's approach also implements several liquidity screens, including a minimum market cap of $75 million for U.S. stocks and $100 million for foreign stocks, and a three-month average daily trading volume of at least 1 million shares.

Some Similarities To MJ

Like MJ, the Amplify proposal wouldn't be pure-play, precisely; rather it would take a holistic, cross-disciplinary approach toward the cannabis industry.

However, it would forgo exposure to tobacco companies, at least at first.

Amplify's prospectus also takes great pains to point out that the companies it invests in will be legal—in fact, using the same language in spots as MJ's prospectus, language which so far has passed muster with the Securities and Exchange Commission.

Index-Based Approach

Of the three filings, only the Innovation Shares proposal would be index-based, but that doesn't necessarily mean it would be a vanilla product.

Details about the index are slim, and Innovation Shares declined to comment for the article, citing the "quiet period" before launch. However, the prospectus lists the Innovation Labs Cannabis Index as its benchmark.

No information about the index has yet been published, but it is likely that the index will resemble the other Innovation Labs benchmarks that underpin the $10 million Innovation Shares NextGen Protocol ETF (KOIN) and the $1 million Innovation Shares NextGen Vehicles & Technology ETF (EKAR).

Those indexes use an AI-driven selection process to evaluate potential constituents, implementing a proprietary natural language processing algorithm that scours public documents and online databases for information to sort and rank companies.

More Limited In Scope

The Innovation Shares proposal would have a smaller global footprint than the other proposed and existing funds, limiting itself to only U.S. and Canadian companies that "have a business interest" in the legal cannabis, hemp or cannabidiol pharmaceutical and consumer wellness and product markets. (The vast majority of legal cannabis companies are domiciled in Canada.)

Like the Amplify proposal, the Innovation Shares fund would implement size and liquidity screens, including a minimum market cap of $100 million and at least 200,000 shares traded during the month of the index reconstitution.

Though the index is market-cap-weighted, individual securities are capped at a 7% weighting, with the excess proportionally redistributed among the remaining constituents.

The index would be reconstituted monthly, on the third Friday of each month.

Contact Lara Crigger at [email protected]

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