Difficulties Creating & Redeeming Shares
All this has real consequences at the ETF level. When APs—the financial institutions whose job is to create and redeem new shares of an ETF by buying/selling shares of the underlying stocks—find it difficult to procure the securities they need, they're discouraged from supporting that ETF.
On top of that, many of these institutions were already reticent to hold cannabis stocks, given their still-uncertain legality at the federal level.
As a result, it isn't unusual for cannabis ETFs to have a limited number of available APs. For example, ETFMG recently stated it had four APs supporting MJ, while THCX has just one. In contrast, many core ETFs have 10 APs or more signed to support a fund.
Fewer APs means less competition when it comes time to create and redeem shares, meaning wider trading spreads for the end user.
"The market makers have to play it safe and keep a larger spread," noted Esposito. "And if there aren't as many market participants, they can have larger spreads and make larger margins. So it becomes a self-fulfilling prophecy."
Does Passive Make For Easier Trading?
Notably, the two passively managed marijuana ETFs, MJ and The Cannabis ETF (THCX), trade with spreads roughly half as wide as those of the actively managed AdvisorShares Pure Cannabis ETF (YOLO) and the Cambria Cannabis ETF (TOKE).
MJ and THCX have average trading spreads of 0.24% and 0.22%, respectively; while YOLO and TOKE respectively have spreads of 0.44% and 0.40%.
Matt Markiewicz, founder of Innovation Shares and portfolio manager for THCX, attributes passive management for THCX's 0.22% spread, which is the tightest of the four ETFs examined.
"Market makers have more comfort we're not going to pull out of our positions frequently and their hedge is going to be left exposed," he said.
Trading Volume Is Paramount
However, active management alone shouldn't necessarily result in higher trading spreads for ETFs. The more likely culprit here is trading volume—"generally the single biggest factor correlated to spread," said ETF.com Managing Director Dave Nadig.
MJ and THCX trade substantially more volume day to day than either YOLO or TOKE. Average volume for MJ and THCX is $12.7 million and $2.3 million, respectively.
For YOLO and TOKE, though, average volumes are respectively $1.2 million and $0.4 million.
Given that TOKE is still a new ETF—it launched on July 25—its relatively higher spread is likely directly the result of its low volume.
In YOLO's case, which has been on the market for four months and has respectable trading volume above $1 million, another root cause may be contributing.
Swaps Contracts To Obtain Exposure
As actively managed funds, both YOLO and TOKE may invest in derivative contracts, a feature that YOLO has used to substantial impact by investing in the swaps contracts of multistate operators (MSOs).
MSOs are marijuana companies operating across multiple U.S. state lines. While their business activities are legal in the states in which they operate, these companies technically remain illegal at the federal level—meaning, among other things, their equities are ineligible to be listed on national stock exchanges.
YOLO is the first, and so far the only, ETF to obtain exposure to MSOs and other companies of uncertain legality through the use of swap contracts. (Swaps are derivatives in which one party agrees to exchange (“swap”) the value or cash flow of a given asset for another. Also see “How Do Swaps Work?”)
"[The use of swaps contracts] removes the actual, direct ownership, which is the real hangup for all nonallowed cannabis stock," said Dan Ahrens, COO of AdvisorShares and YOLO's portfolio manager.