Talk about getting off to a great start.

Horizons Marijuana Life Sciences Index ETF (HMMJ 0.11%) launched in April of last year. It generated a return of nearly 85% in 2017, much better than many ETFs that had the full year to rack up gains. So far in 2018, the marijuana ETF is up by a double-digit percentage. That means the Horizons marijuana ETF has more than doubled since inception. A great start indeed.

With any investment, though, the potential for high returns comes with high risks. That's true for Horizons Marijuana Life Sciences Index ETF. But how risky is this top marijuana ETF?

Measuring the word "risk" with calipers

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A little background

Currently, Horizons Marijuana Life Sciences Index ETF (HMMJ) only trades on the Toronto Stock Exchange (TSX). However, it has attracted plenty of interest from U.S. residents, who can buy shares if their broker can execute orders on the TSX.

HMMJ attempts to track the performance of the North American Marijuana Index. Expenses, which currently include a 0.75% annual management fee plus applicable sales tax, drag performance down a little from the index, though.

The North American Marijuana Index includes leading cannabis stocks operating in the United States and Canada. HMMJ, though, currently won't invest in any stock primarily focused on the medical or recreational marijuana market in the U.S., or the recreational marijuana market in Canada.  The ETF can invest, however, in marijuana companies which derive a smaller portion of their total revenue from the marijuana industry in U.S. states where cannabis use has been legalized by state law, whether for medical or recreational use.

Assuming Canada legalizes recreational marijuana as expected later this year, the ETF is likely to open up its coffers for investing in stocks targeting that market. And, if the U.S. ever legalizes medical and/or recreational marijuana at the national level, you could expect HMMJ to invest significantly in stocks poised to benefit from such legalization.

Identifying the risks

One thing many investors like about ETFs, in general, is that they spread risk across a large number of individual stocks. It's important to know that HMMJ holds positions in only 30 stocks, much fewer than many ETFs.

Marijuana buds on small Canadian flags

Image source: Getty Images.

Also, HMMJ's risk is heavily concentrated in just a handful of marijuana stocks. Currently, the top four holdings -- Canopy Growth (CGC -2.43%), Aurora Cannabis (ACB 0.95%), Aphria (NASDAQOTH: APHQF), and MedReleaf -- combine to make up over half of HMMJ's investments. Nearly 80% of HMMJ's investments are in just 10 stocks.

Practically speaking, this means HMMJ is more risky than many ETFs on the market simply because of its concentration of risk in so few stocks. However, there's also risk from the stocks themselves.

Roughly four-fifths of HMMJ's money is invested in the stocks of Canadian medical marijuana growers, including the top four holdings. The medical marijuana market has grown tremendously in recent years. However, companies like Canopy Growth and Aurora are anxiously awaiting the expected legalization of recreational marijuana in July of this year. Experts think the market size should be at least $4.2 billion annually and potentially much higher

There are a couple of key risks for these Canadian marijuana stocks, though, that translate to significant risk for HMMJ. One is that legalization of recreational marijuana could be delayed. Another is that the market won't be as great as anticipated. With the valuations of these stocks already at sky-high levels, any obstacles to the companies achieving the expected sales growth would be bad news for HMMJ.

Nearly 13% of the ETF's money is currently in biotechs focused on cannabinoid development, with GW Pharmaceuticals (GWPH) at the top of the list. Of course, biotech stocks come with their own kinds of risks. GW Pharmaceuticals' market cap, for example, already factors in anticipated approval for the company's cannabidiol (CBD) product Epidiolex later this year. If Epidiolex doesn't win that approval, the stock would plunge. There's also the possibility that clinical study results for other programs aren't successful, which could weigh on the stock. 

Risk in the eye of the beholder

Is Horizons Marijuana Life Sciences Index ETF too risky? That depends on the individual investor. For some, the marijuana ETF is definitely too risky. For others, the potential returns could justify the risks in buying HMMJ.

My guess is that most Canadian marijuana stocks will generate solid gains in 2018 assuming recreational marijuana legalization isn't derailed. As they go, so goes Horizons Marijuana Life Sciences Index ETF. This top marijuana ETF is certainly risky, but there's also a huge potential for rewards.