Investors are more excited about the marijuana market than ever, and stocks in the cannabis space have seen dramatic gains to start the year. As a result, the biggest marijuana ETF in the business, the ETFMG Alternative Harvest (NYSEMKT:MJ), has rewarded its investors with nice returns so far in 2019.

ETFMG Alternative Harvest holds a variety of different marijuana stocks, and as you'd expect, you'll find some of the biggest cannabis companies in the budding industry at the top of its holdings list. Recently, movements in the share price of various marijuana stocks led to the ETF having a huge concentration in one particular cannabis company, and that raised some red flags among marijuana investors. Interestingly, though, ETFMG followed up by making a big move that wasn't entirely expected. A closer look at the ETF's investing materials, however, makes it clear that Alternative Harvest's decision was completely in line with what it's disclosed to investors -- even if most of those investors haven't read about it.

Cannabis leaf on top of a pile of $100 bills.

Image source: Getty Images.

A big change in weightings for Alternative Harvest

Earlier this month, I noticed that shares of a single marijuana stock represented almost 20% of Alternative Harvest's assets. That seemed surprising at first glance, as the index that the ETF tracks purports to use a modified market-cap weighting methodology that would typically have given the biggest companies in the space the greatest weighting. A closer look at the methodology that the index used, however, showed how a unique confluence of factors could have led to the overweighting.

With the index provider saying that rebalancing and reconstitution takes place during the last month of each calendar quarter, it seemed as though investors would have to put up with the high weighting for at least a month or more. However, surprisingly, the weightings came much more closely into line shortly afterward. Below, you can see the before-and-after weightings for some of the most important marijuana stocks in the market.

Stock

Weighting as of Feb. 5

Weighting as of Feb. 12

Cronos Group (NASDAQ:CRON)

18.6%

7.6%

Canopy Growth (NYSE:CGC)

8.7%

7.5%

Aurora Cannabis (NYSE:ACB)

7.7%

7.3%

Tilray (NASDAQ:TLRY)

5.6%

7.5%

OrganiGram Holdings (NASDAQ:OGI)

4.4%

3.2%

Data source: ETFMG.

What appears to have happened is that the ETF made moves to rebalance its portfolio. The reason that's surprising is that February wouldn't seem to be a typical time for such a rebalancing to take place.

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What the marijuana ETF can do

That prompted a closer look at the prospectus for Alternative Harvest to see what additional light it could shed on the situation. Early on, the prospectus makes a pretty general statement, noting that "the index is reconstituted and rebalanced quarterly." That's consistent with the language that you'll find on the Prime Indexes website, as the provider of the Prime Alternative Harvest Index notes the quarterly reconstitution in March, June, September, and December.

However, later in the prospectus, Alternative Harvest makes it clear that the ETF retains greater discretion to take steps to modify its portfolio even in between those quarterly rebalancing moves. Specifically, the prospectus says:

In order to minimize the market impact of an index rebalance, the fund may begin trading to effect the rebalance in advance of the effective date of the rebalance [emphasis added] and continue trading after the effective date of the rebalance, which may contribute to tracking error.

This seems to be exactly what happened during early February. Having identified that the March rebalancing would result in a dramatic shift in the ETF's portfolio to reduce the weighting of Cronos Group in favor of some of the fund's smaller holdings, ETFMG chose not to wait that long to make its move. Instead, it used its discretion under the prospectus to make moves in advance of the effective date of the rebalance -- accepting any resulting disparity between the fund's return and the index's return over the period.

Marijuana investors: Know your ETF

None of this should be surprising to those who've read the Alternative Harvest ETF's investing materials in full. The problem is that most investors never even look at the prospectus, let alone read it in its entirety. As a result, when things like this happen, it can come as a shock -- even if the fund itself gave full notice to investors that it reserved the right to do so.

With Alternative Harvest showing strong gains for the year, most investors won't really care about the big move that the ETF made to its holdings. However, knowing that the marijuana ETF can use its discretion is important so that if it happens in the future -- at a more critical time in the industry -- you won't get blindsided as an investor.