Why Is Almost 20% of Marijuana's Biggest ETF Invested in 1 Pot Stock?

Cannabis investing has been hugely popular recently, and the surge in pot stock prices to start 2019 has driven a lot of interest in the industry. In particular, the landmark exchange-traded fund ETFMG Alternative Harvest (MJ 2.01%) has been hugely successful, recently topping the $1 billion mark in assets under management and seeing good gains to begin the year.

But even though investors don't typically ask questions when things are going well, there's one thing about ETFMG Alternative Harvest that's hard to explain. As of Feb. 5, despite holding three dozen stocks in its portfolio of holdings, Alternative Harvest has almost a fifth of its assets invested in a single stock -- and it wasn't even the biggest company in the market. Even though most cannabis investors have paid most of their attention to a small number of first-moving stocks in the field, Alternative Harvest's particular mix raises some questions about the methodology that the underlying Prime Alternative Harvest Index uses to select and weight the stocks in its investing universe.

Alternative Harvest's biggest holdings

You can see below a list of Alternative Harvest's top five stock holdings as of Feb. 5:

Data source: ETFMG, Yahoo! Finance.

At first glance, this weighting scheme looks pretty odd. Most ETFs use a system that's based on market capitalization, giving the largest companies the highest weightings. Using such a system, you'd expect Canopy, Aurora, and Tilray all to have much larger weightings than Cronos, because their market capitalizations are anywhere from two to five times higher than Cronos' market cap.

However, not all indexes use straight market-cap weighting. On its website, ETFMG refers to its tracking index, the Prime Alternative Harvest Index, as its primary authority in making investment decisions. The prospectus makes limited references to the actual methodology that the index follows, instead focusing on how it takes the information that the index provider gives it and uses it to make its own investing decisions.

Image source: Getty Images.

Prime Indexes has a website as well, but its information is limited. It refers to its methodology as a "modified market cap" weighting scheme. But even though many of the other indexes it offers have detailed descriptions of the methodologies they follow in separate PDF documents, there's no such link on the page describing the Alternative Harvest index.

What's going on?

What's likely to be the cause of the current situation is a confluence of events that brought Cronos into the spotlight recently. In particular, the following appears to be the case:

• The index would have gone through a typical reconstitution in December.
• If the index uses the same modified market cap approach as some of its Prime Indexes peers, then the overweight percentages that would've applied to stocks like Canopy, Aurora, and Tilray would've been artificially reduced and redistributed to smaller-cap stocks like Cronos.
• Since the beginning of December, Cronos has dramatically outperformed Canopy, Aurora, and Tilray. Cronos shares have doubled over that time frame, compared to gains of 35% to 40% for Aurora and Canopy and a roughly 25% decline for Tilray.

In other words, what's likely to have happened is that as of the most recent rebalancing in December, most of the top marijuana stocks would've had roughly equal weightings because of the specific restrictions in the index methodology. Ironically, those restrictions were designed to prevent the very overweighting issue that has since resulted. The huge gains for Cronos following the decision of tobacco giant Altria Group (MO 0.10%) to invest in the cannabis company were responsible for putting the ETF's weightings out of whack.

Much ado about nothing?

ETF proponents will argue that any such overweighting should be a temporary phenomenon. When the ETF next does its rebalancing in March, the methodology should work to pull Cronos Group's weighting back down into line with its peers. From there, relative performance could again lead to overweight or underweight positions within the portfolio, but it would take massive share-price movements to create the same situation again.

Nevertheless, for at least the next month, investors in Alternative Harvest need to understand that they're making an outsized bet on the performance of Cronos Group. If it underperforms its marijuana stock peers, then it could have a detrimental impact on how Alternative Harvest does compared to the cannabis investment universe more broadly. That's a risk that many ETF investors aren't familiar with taking -- but they'll need to take it into account here.