Marijuana ETFs: How to Find the Best Exchange-Traded Funds

The North American marijuana market is expected to skyrocket from about $9.2 billion in 2017 to $47.3 billion by 2027, according to Arcview, and as a result, pot profits could soar for marijuana companies over the next decade. The investing opportunity is potentially massive, but there are big risks to investing in cannabis. Marijuana remains illegal in the U.S. at the national level, so U.S. marijuana stocks are hamstrung by laws that increase their taxes and reduce their access to banking services. Furthermore, investments in marijuana production could result in too much supply, causing a drop in marijuana prices per pound that could hurt growers in the future.

Unfortunately, there's no way to completely eliminate the risks associated with investing in marijuana, but owning a collection of marijuana companies could insulate you against any one company disappointing. If you're interested in diversifying your exposure to this growth industry, a marijuana exchange-traded fund (ETF) could be your best bet. Here's what you should know about the evolving cannabis market and your ETF alternatives. 

Image source: Getty Images.

What is marijuana?

Marijuana is the dried flower of the female cannabis sativa plant. It contains over 100 chemical cannabinoids, but the most common cannabinoid is tetrahydrocannabinol (THC), a psychoactive chemical that's found in the resin produced by the leaves and buds of the female cannabis plant.

The second most common cannabinoid in cannabidiol (CBD), a nonpsychoactive chemical that helps counteract the high produced by THC.

When people use marijuana, these cannabinoids interact with receptors in our body's natural endocannabinoid system. There are two types of cannabinoid receptors: CB1 receptors that are located primarily in the brain and CB2 receptors that are mostly found elsewhere. THC's interaction with CB1 receptors is what's responsible for marijuana's psychoactive effect, while the interaction of marijuana's other cannabinoids with CB2 receptors is believed to contribute to many of marijuana's medicinal benefits, including its ability to help regulate seizures in epilepsy.

Cannabis history

Impressions from rope made from hemp, a low-THC variety of cannabis sativa, have been observed in pottery dating back to 5,000 BC and cannabis seeds have been found in the graves of people buried in China and Siberia dating back to 500 B.C. 

Cannabis was predominately grown to produce hemp fibers for the manufacture of rope and textiles, but hashish, a purified cannabis, has been widely used in the Middle East and Asia since at least 800 A.D.

A fast-growing plant, cannabis is easily cultivated, particularly in warm climates. It can be planted on the same fields repeatedly without depleting soil nutrients, and because of the strength of its fibers, it was a key crop grown by U.S. colonists after their arrival in America. In fact, it was so important to England that colonists were required to grow hemp for cloth, paper, sacks, and sails on at least some of their farmland. Similarly, farmers were encouraged to grow hemp during the American revolution to overcome textile shortages due to embargoes.

Cannabis use in the U.S. was primarily industrial, but it also has a long history of use as a medicine. For instance, its use in stomach ailments increased throughout the 19th century after Sir William Brooke O'Shaughnessy discovered in the 1830s that cannabis extracts helped relieve stomach pain caused by cholera. By the late 1800s, cannabis extracts could be bought throughout Europe and the United States at pharmacies.

The recreational use of marijuana in the U.S. accelerated in the early 1900s because of an influx of immigrants because of the Mexican Revolution. Between 1910 and 1930, there was a tripling of immigration to the U.S. from Mexico, where marijuana had become widely used after its introduction during Spanish colonization. 

Mexico passed laws making recreational marijuana illegal in 1920, and by the 1930s, most U.S. states had also passed laws regulating marijuana. Recreational marijuana was finally made illegal federally in 1937 when the U.S. Congress passed the Marijuana Tax Act.

In 1970, the Marijuana Tax Act was replaced by the Controlled Substances Act, which created America's current drug scheduling system. Marijuana was listed as a Schedule I drug, which is the category for drugs with a high risk of abuse and without a medical use, and it's remained a Schedule I drug ever since.

The first state to legalize medical marijuana was California in 1996, but 30 states have legalized marijuana in some form since then, including nine states that have legalized it for recreational use. 

The marijuana market today

Despite many states passing laws allowing marijuana's use, marijuana's federal status continues to be an obstacle that's holding the industry back in America. Marijuana companies don't have access to traditional banking services and they're unable to deduct many business expenses from their taxes, such as administrative costs. The federal prohibition of marijuana also creates obstacles to operating across state borders.

Nevertheless, the U.S. retail marijuana market is already worth billions of dollars per year, and it's growing quickly. According to GreenWave Advisors, the U.S. retail marijuana market was worth about $8.2 billion last year, up from $6.5 billion in 2016.

It's not just the U.S. market that's expanding, though. Demand is also growing rapidly in Canada, where the use of medical marijuana has been accelerating since legislation created a fully functioning medical marijuana market in 2013. In 2017, about 4.9 million Canadians spent $4.6 billion on legal medical and illegal recreational cannabis, according to Statistics Canada. However, that may only be the tip of the iceberg. Canada's market is expected to swell in October 2018 when its recreational marijuana market opens for business nationwide. According to Deloitte, Canadians will spend $7 billion on marijuana in 2019, including $4.3 billion that will be spent on recreational marijuana. 

Outside North America, important marijuana markets are also emerging in Europe. Germany, the largest member state of the European Union, established a medical marijuana market in 2017, and 13,000 people signed up for the program during its first 10 months. Since Germany's home to 82 million people -- twice the population of Canada -- it could represent a big opportunity for marijuana investors. 

Overall, Arcview estimates that worldwide spending on marijuana could reach $57 billion by 2027, including $47.3 billion in North America.

Image source: Getty Images.

Marijuana stocks

The marijuana market's rapid growth suggests that investing in marijuana stocks could be rewarding. Unfortunately, investors have limited options in terms of marijuana stocks. 

In the U.S., most cannabis companies trade on the over-the-counter market. This market, which is sometimes referred to as the pink sheets because of the color of the paper that its stock prices are quoted on, has less stringent listing requirements than the New York Stock Exchange or the Nasdaq. The wild, wild West of exchanges, the pink sheets are often home to penny stocks, and the companies that list on it have historically been more prone to fraud. 

If you want to invest in Canada's marijuana stocks, then you'll have to buy them on Canadian stock exchanges, including the Toronto Stock Exchange, or you'll have to buy American depositary receipts (ADRs) that track their performance in Canada. There are a few exceptions, though, including Canopy Growth Corporation, a $5.6 billion market cap Canadian marijuana company that listed on the New York Stock Exchange earlier this year. In fiscal 2018, Canopy Growth generated $78 million in sales, and as a result, it's one of Canada's biggest marijuana companies. It won't give you exposure to the United States marijuana market, though, because management decided to avoid the U.S. until it ends federal prohibition.

Another Canadian marijuana stock that trades on the major U.S. market exchanges is Tilray Inc., which became the first Canadian marijuana stock to list directly on the Nasdaq in 2018. Tilray generates about 45% of its revenue from cannabis oil sales, which historically command higher prices and offer better profit margins than dried marijuana flower. That's a significantly higher percentage than its peers, including Canopy Growth, which generated less than 30% of its sales from oils in its fiscal first quarter of 2019. Tilray's dominance in oils positions it to capture a healthy share of the medical market and edible marijuana markets made it one of 2018's hottest marijuana stocks to own. 

If investors want exposure to the U.S. market, but they don't want to risk buying pink sheet stocks, then their next best option is to buy backdoor marijuana stocks, such as industry suppliers or marijuana drugmakers. However, those are imperfect ways to invest in the industry. For example, The Scotts Miracle-Gro's Hawthorne business supplies marijuana growers with solutions, including hydroponics, but marijuana represents only a sliver of the company's overall performance. In second-quarter 2018, Hawthorne accounted for less than 7.5% of Scotts' sales. 

Similarly, marijuana drugmaker GW Pharmaceuticals, recently secured approval for its CBD-based epilepsy drug, Epidiolex, but investing in that company won't give you exposure to Canada's or America's recreational marijuana market. Also, the Food and Drug Administration approval of Epidiolex is initially for its use in patients with very rare forms of epilepsy, suggesting it may be a while before it becomes widely used. Currently, its approved, addressable market totals less than 40,000 people in the U.S.

Marijuana ETFs

Because individual marijuana stocks are imperfect options for investing in this industry, ETFs might be a better alternative. Like a mutual fund, an ETF pools together money from investors to make investments according to its prospectus -- a legal document that explains the fund, its finances, management, expenses, strategy, and other important information. However, unlike mutual funds, but like individual stocks, ETFs can be bought or sold at any point during the trading day, giving investors more flexibility.

There are ETFs that invest in stocks, bonds, and commodities. Typically, ETFs invest in stocks passively by tracking the stocks included in an underlying index. These indexes can be created by third parties, such as the Standard and Poor's S&P 500 index, or by the ETF's issuer.

Due to the growing interest in marijuana investing, investment companies have begun launching ETFs that invest solely in cannabis stocks. The two largest marijuana ETFs are the Horizons Marijuana Life Sciences Index ETF (HMMJ -2.47%) and the ETFMG Alternative Harvest ETF (MJ 1.35%).

Horizon's fund trades on the Toronto Stock Exchange, but investors can buy shares on the over-the-counter market, too. It tracks Arcview's North American Marijuana Index, an index that's primarily made up of U.S. and Canadian marijuana or hemp companies.

Instead of investing the same amount of money in each stock listed in the index, Horizon determines each stock's weighting by its market cap every quarter. When the ETF rebalances its weightings every quarter, it caps the maximum weight for any one stock at 10%.However, these weights can become much bigger than that in between its quarterly rebalancing. For instance, in September 2018, the ETF had over 10% of its assets in both Aurora Cannabis, a Canadian marijuana stock, and Canopy Growth, and it held over 30% of its assets in its top three holdings: Canopy Growth, Aurora Cannabis, and GW Pharmaceuticals.

The ETFMG Alternative Harvest ETF is the first marijuana-focused exchange-traded fund to list on the New York Stock Exchange's Arca exchange. Its $341 million in assets track the Prime Alternative Harvest Index.

The ETFMG ETF is also a market cap-weighted fund, but with a twist: It can adjust the weights based on a review of the company. For instance, one of the ETF holdings is the $109 billion market cap Altria, but since Altria derives most of its money from tobacco, not marijuana, its weight in the ETF is only 1.76%. For comparison, Aurora Cannabis weight just shy of 10% despite its much smaller market cap.

The following table shows the largest holdings of these two ETFs as of September 28, 2018. Although the top 10 biggest marijuana stocks held in these ETFs is similar, the weights differ substantially. As a result, their performance could be very different depending on the returns they generate from their biggest holdings.

ETFMG Alternative Harvest ETF

Data source: ETFMJ and Horizons ETFs.

Horizons Marijuana Life Sciences Index ETF

Data source: ETFMJ and Horizons ETFs.

How to pick the right ETF

Marijuana stock investors with a deep understanding of the marijuana market and the individual marijuana companies participating in it may prefer owning a small number of marijuana stocks, rather than an ETF that owns many marijuana stocks. However, the complexity associated with an emerging and highly regulated market like this makes accumulating that level of knowledge an arguably full-time occupation. So if you're not incredibly comfortable with the risks associated with investing in the wrong individual marijuana stock, then buying an ETF that owns a diversified collection of marijuana market participants may be smart.

Picking the right ETF to buy can be hard, but considering portfolio turnover and expenses can make it simpler. Investment portfolios that don't buy and sell stocks frequently, or low-turnover funds, historically outperform high-turnover funds, and low-fee funds tend to generate better long-term returns than high-fee funds. Included among the fees charged by ETFs are administrative fees, regulatory compliance fees, distribution fees, management fees, marketing fees, shareholder services fees, and record-keeping fees. These fees are bundled together and charged as a percentage of net assets that are invested in the fund, or assets under management. This is usually referred to as the ETFs expense ratio. Typically, funds with more in assets under management have a lower expense ratio than those with less money under management because of the benefits associated with scale. 

Unfortunately, neither of these ETFs has a long track record, so it's difficult to determine which may wind up having less turnover in holdings over time. As for fees, the Horizons Marijuana Life Sciences ETF has a 0.94% expense ratio and the ETFMG Alternative Harvest ETF expense ratio is 0.75%. Because more of your money will stay in your pocket rather than the investment managers, the ETFMG ETF could be a better bet.

Should you buy these ETFs?

The Horizon Marijuana Life Sciences Index ETF and the ETFMG Alternative Harvest ETF provide diversified exposure to the marijuana industry, but the different weightings in the respective portfolio could make their performance differ meaningfully from each other. For example, Horizon's ETF has nearly 7.5% of its money in Scotts Miracle-Gro, while it doesn't even crack the top 10 holdings list for ETFMG's ETF. Similarly, the ETFMG fund invests in tobacco companies and the Horizon fund doesn't. Those differences in weights and holdings could be enough to sway investors away from one of these ETFs toward the other.

Of course, that doesn't necessarily mean that either of these ETFs is a wise investment. Any number of things could derail share prices in the underlying stocks owned by these funds. For instance, regulators could change the rules associated with securing licenses to manufacture and sell marijuana or lawmakers could change the taxes charged on marijuana production and retail sales, negatively impacting revenue and profitability. There's also the risk that sales could be negatively impacted by unforeseen health consequences associated with rising marijuana use or that countries that are expected to embrace pro pot laws don't change their minds. In short, these are risky investments that are best suited to only the most aggressive and risk-tolerant investors.

That having been said, I favor the ETFMG Alternative Harvest ETF because its assets aren't as concentrated in its top three holdings, its expense ratio is lower, and it's traded on the New York Stock Exchange. I haven't invested any of my own money in it marijuana stocks yet, but that's the marijuana ETF I'll consider buying if I do.