US Marijuana ETF Boom Stalls

The ETFMG Alternative Harvest ETF (MJ) started off 2018 with a bang.

Fresh off a controversial index change at the end of 2017 that swapped its flagging Latin American real estate index for one that tracked legal cannabis companies, MJ attracted a whopping $401 million in new net inflows during the first two months of the year.

Excitement around the fund was high; in fact, Bloomberg Senior ETF Analyst Eric Balchunas even said that MJ was "on pace to take in $1 billion" or more.

And then … nothing.

Since March 1, MJ—now at $408 million in assets under management—has brought in just $14 million in new net inflows. In fact, the fund hasn't seen any net flows since June 12, shortly after President Trump announced he was likely to back legislative efforts to let states decide whether to legalize marijuana. Prior to June 11, MJ hadn't seen any new money since April.

Not even the Canadian Senate's vote on June 20 to officially legalize recreational marijuana nationwide moved the needle for MJ (56% of the ETF by weight is in Canadian-listed stocks). So where did all the excitement for marijuana ETFs go?

MJ's Performance Lags

MJ's lack of inflows isn't due to lack of investor interest in the space, as the fund consistently ranks among the top most-searched-for ETFs on our site (read: "Most Searched ETFs On ETF.com").

Instead, MJ's lackluster performance is more likely to blame. Though MJ saw a performance spike shortly after it switched indexes on Dec. 26, 2017, mirroring a similar spike in marijuana stocks as a whole, the fund's returns ever since have been anemic. Year-to-date, MJ is down 2.25%:

(Longer-dated historical returns for MJ may look impressive, but keep in mind they are irrelevant. On a one-year basis, MJ is up 11.9%. That figure, however, includes returns from before MJ switched indexes.)

Dragged Down By Tobacco Stocks

At first, it may seem counterintuitive that MJ's year-to-date performance is so low, considering the marijuana sector has been buoyed by the Canadian legalization push. The North American Marijuana Index, which tracks cannabis companies in the U.S. and Canada, is up 19% over the past six months.

Individual marijuana companies have fared much better. For example, the stock prices of MJ's top three holdings—The Green Organic Dutchman, MedReleaf Corp. and Canopy Growth Corp.—have risen 77%, 35% and 41% year-to-date, respectively:

However, MJ's 22% weighting to tobacco stocks—which many experts consider a forward-looking play on the cannabis space—has likely dampened fund returns.

Performance of the tobacco sector is far more mixed. For example, the top three tobacco-related stocks in MJ—Turning Point Brands, 22^nd Century Group and Philip Morris—are up 48%, down 14% and down 22% year-to-date, respectively:

Charts courtesy of StockCharts.com; data as of June 25, 2018

On the other hands, the AdvisorShares Vice ETF (ACT), which tracks a mixed portfolio of alcohol, tobacco and cannabis stocks, has seen slightly better year-to-date performance: -0.72%. ACT's outperformance relative to MJ is likely due to the fact that ACT holds more than half its portfolio in alcohol stocks, such as Boston Beer Co., Constellation Brands and MGP Ingredients, which are up 58%, 0.35% and 22% year-to-date, respectively.

As for the rest of its holdings, ACT holds roughly 20% in marijuana companies and 26% in tobacco stocks. Investors have yet to respond to ACT's particular blend of "vice" stocks, however: The $13 million ETF has brought in just $5.4 million in new money year-to-date.

Custodial Risk Still Hazy

Risk may also explain why investors have been avoiding marijuana ETFs, including custodial risk, which ETF.com has reported on in the past and which remains unresolved (read: "Promise & Peril Of Marijuana ETFs").

Even though most marijuana stocks are domiciled in Canada, many U.S. custodian banks still refuse to take on the reputational, and possible legal, risk of holding stocks whose business remains federally illegal in the States, at least when doing so for an explicitly cannabis-themed fund. That could run them afoul of federal banking laws, risking the bank's FDIC insurance or even its license.

The two issuers with cannabis-themed ETFs approached this risk differently. ACT's issuer, AdvisorShares opted for nonpure-play cannabis exposure, working closely with its custodian to select only U.S.-listed marijuana securities that had been registered with the Drug Enforcement Agency.

Meanwhile MJ's issuer, ETF Managers Group, effectively circumvented its own custodian by swapping the benchmark for an existing fund, LARE, in favor of a marijuana index. The ETF was then relaunched as MJX, later renamed MJ (read: "When An ETF Changes Its Exposure") .

It remains unclear whether the fund's custodian, U.S. Bank, plans to or has taken any action with ETF Managers Group over the index switch, which was done without its prior approval. As more time passes, however, the less likely it becomes that U.S. Bank will amend or terminate its relationship with MJ.

Indeed, the newest ETFMG fund, the Breakwave Dry Bulk Shipping ETF (BDRY), still lists U.S. Bank as custodian in the fund prospectus, underscoring the continuing relationship between the two entities.

US Regulatory Future Uncertain

The other big risk of marijuana ETFs is the persistent uncertain regulatory future for the underlying stocks.

In the U.S., public sentiment appears to be in favor of marijuana legalization, either federally or on a state-by-state basis. Lawmakers have introduced bills to legalize marijuana at the federal level in both chambers of Congress, while President Trump has indicated his preference to leave the question of legalization up to individual states.

Yet U.S. Attorney General Jeff Sessions fiercely opposes legalization. In April, he rescinded Obama-era protections for marijuana companies that are legal on a state level. Sessions has also formed a task force to investigate the connection between marijuana and violent crimes.

With several states putting marijuana measures on the ballot this coming election season, the question of legality may come to a head this fall. If the question of legality finally gets resolved, though, it would profoundly impact marijuana stocks in the U.S. and abroad, and potentially open up an estimated multibillion-dollar market.

That could also eliminate the custodial risk associated with marijuana ETFs, thereby making it possible to launch new marijuana ETFs in the U.S. Many already-proposed funds have stalled before the SEC, and no new marijuana ETFs have been proposed this year.

Canadian Marijuana ETFs Boom

Meanwhile in Canada, Toronto-listed marijuana ETFs have boomed, particularly on the optimism generated in anticipation of and after the country's vote to legalize recreational marijuana. (June 20's vote was the last step in a multichamber process, and full legalization is set to take effect Oct. 17.)

The world's first marijuana ETF, the $868 million Horizons Marijuana Life Sciences Index ETF (TSE: HMMJ), is up 119% over the past 12 months, and has attracted more than $350 million in net inflows year-to-date.

Two additional Canadian marijuana ETFs were also introduced to market earlier this year: the $12 million Horizons Emerging Marijuana Growers Index ETF (CN: HMJR), which tracks junior North American pot growers; and the $5 million Evolve Marijuana ETF (TSE: SEED), an actively managed fund. (Performance data for HMJR and SEED are not available. Canada restricts the publication of those numbers until a fund has a one-year track record.)

Earlier this month, Horizons also filed for three leveraged marijuana ETFs offering -1x, 2x and -2x exposure to the daily returns of a benchmark tracking solely Canadian marijuana companies. Part of the rationale was to give investors more options to short marijuana stocks.

"We've noticed there is significant demand from investors to short marijuana stocks," Steve Hawkins, president and co-CEO of Horizons ETFs told The Globe And Mail, adding that HMMJ has benefited from this demand by lending out its underlying securities and providing revenue for shareholders (read: "Is Securities Lending Good For ETF Investors?").

Contact Lara Crigger at [email protected]