Don’t Look for a Cannabis ETF Anytime Soon

Passive investing is the mainstay of American wealth building. Ushered in by the likes of John Bogle and Vanguard more than 40 years ago, most of us keep the majority of our invested assets in index funds and ETFs, which track broad stock baskets like the S&P 500 or fixed income assets like Treasury bonds. The premise is simple and powerful—one single purchase to get exposure to a group of assets, reducing the risk of any one bombing out while participating in long-term trends.

In the past few years, literally thousands of ETFs have popped up, and for increasingly focused themes like individual countries, sectors, industries. Some of them are so specific in their focus that it begs the question, most recently posed by Bloomberg: Will we ever see an ETF focused solely on cannabis?

The attractiveness of an ETF that could lower the volatility and risk of making an investment into a single cannabis stock is quite evident. But is it feasible? Bloomberg suggests no, and we concur, and the reasons lie in the math. Because while there are technically enough stocks in number (the Bloomberg piece cites 55 stocks which are directly involved in the business) to form an ETF with, there is not nearly enough in total market capitalization.

 

Reason #1 – Too Small, Too Fragmented

The combined total of all the market caps within the cannabis universe right now is rather paltry—around $4 billion. In order for fund managers to create new ETFs, they need to know that they can handle the inflow of investors who will bring their dollars around to participate. While it’s impossible to know just how popular a given ETF will be, fund managers, called sponsors, would need to prepare for tens of millions, if not hundreds of millions, in assets to flow into their new fund.

With so many of the cannabis equities trading on over-the-counter exchanges, there simply isn’t enough average daily money flow to make a pot ETF stable. Fund managers would have to start gobbling up huge percentages of the average trading volume in stocks that already have massive amounts of day-to-day volatility.

The financial wizards on Wall Street have invented a way to get around this particular issue by creating exchange-traded-notes, which operate in almost the exact same way as an ETF. You may already be invested in some ETNs right now and not know the difference between them and a vanilla ETF. But an ETN doesn’t actually go out and buy the individual stocks; the fund sponsor instead creates a paper index and issues promissory notes to investors.

The promise to pay back the returns of the underlying index is done seamlessly, as fund sponsors have quants draw up hedges and insurance contracts to make sure that sponsors aren’t putting out obligations which may expose them to huge losses if the market becomes suddenly volatile, like the cannabis markets have been for the past 16 months.

It must be noted, however, that ETNs are inherently riskier than their ETF counterparts, and usually trade with higher expense ratios. But even if bold fund sponsors wanted to attempt this with cannabis ETFs, they’d still be tripped up by an uncrossable ocean of regulatory obstacles.

 

Reason #2 – The Elephant in the Room

Creating, marketing and distributing an ETF on national stock exchanges that focuses on a federally illegal product is the big, bright, pink elephant in the room. Even if cannabis were removed from the Schedule I list, there would still be a couple dozen states where a fund manager would have to individually vet the ability to market to investors.

There would still be the stigma of a “sin product,” which is why you don’t see any tobacco ETFs for instance—even though there is more than enough market cap and daily liquidity for an ETF to cater to it. There is an image issue, even when cannabis becomes legal that will still loom large over the industry. We believe that this will be sifted out over time, as we are confident in our standing on the right side of history.

But fund managers are in it to make money, not earn social progress badges. Until the back-end costs (legal, regulatory, risk management, operational) of setting up cannabis ETFs are not so prohibitive, investors are left to conduct their own due diligence. We understand our role in helping investors do this necessary research, and take it seriously.

 

The Asterisk Solution … Taco Bell?

A potential “end around” proposed by Bloomberg, and used effectively in some other ETFs, would be to create a product that doesn’t try to “touch the leaf” with every stock in the basket, but instead includes potential derivative/ancillary plays. There are homebuilder-themed ETFs, for instance, which include Home Depot (NYSE: HD), even though Home Depot isn’t in the business of building houses per se.

Some analysts have suggested that a cannabis-themed ETF should include names like Scotts Miracle-Gro (NYSE: SMG) or Lindsay Corp (NYSE: LNN), which could see growth in a world with a burgeoning legal cannabis industry. While this is quite true, the fact is that these companies are already so big that the incremental growth in revenue would not be in line with the growth in cannabis industries themselves. They would be very indirect plays at best.

The same goes for notions like Pepsico (NYSE: PEP) and Yum! Brands (NYSE: YUM) the makers of the supremely munchable fast food munchies. These companies dwarf the entire size of the cannabis industry over tenfold; all cliches about Dorito-chomping aside, unless everybody in the country lit up at once, the liberalization of cannabis can’t be expected to surge these companies’ profits.

For now, the best road for investors may be winding, and not so well paved in places, but it’s the only road we have. Do the homework, avoid the potholes, and be content with being patient when needed. Those who believe in the industry know that the surface is just being scratched, and that homework done now will provide value for many years to come.

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