Investing in cannabis can be exciting, but daunting. Valuations have risen, deregulation could be on the way, and predicted market growth is promising. The U.S. legal cannabis market is projected to climb to upwards of $41.5 billion by 2025. That number would be up from just $13 billion in 2019.

So, you've decided that you want to get in on the action but don't want to bet the farm on a risky investment. There are so many options out there, and so many ways to become confused by the field and its players. Do you go with U.S. domestic cannabis stocks, Canadian, or other international brands? Legalized medical cannabis or recreational? Growers or retail? I think I have just the solution. 

Woman in cannabis greenhouse holding cash and a marijuana plant _

Image source: Getty Images.

The ABCs of ETFs

There's no such thing as a sure thing -- especially in the stock market. But there are ways to minimize the risk that comes with investing in just one or two cannabis stocks. Investing in an ETF is one of those ways. An ETF, or exchange-traded fund, acts much like a mutual fund, and allows investors to buy multiple stocks at once. The main difference between the two is that ETFs can be traded like stocks, throughout the day, whereas mutual funds are traded based on price at the end of the day.

Let's say you've started your research by figuring out which individual stocks you like. But you have hesitation about which group of stocks, or which ETF, will give you the best shot at making some money. Let's dive into three top cannabis ETFs and learn how to make the best selection.

Digging into ETF allocation

The table below consists of three different ETFs that focus on the cannabis market. In the left column are the top stocks held the most within the various ETFs. Under each column header is the asset weight (%) that the ETF holds for that respective stock. As an example: Horizons Marijuana Life Sciences Index ETF (OTC:HMLSF) has 13.2% of its total holdings in Aphria, and Global X Cannabis ETF (NASDAQ:POTX) has 9.3% of holdings dedicated to the company's shares. The AdvisorShares Pure Cannabis ETF (NYSEMKT:MSOS) doesn't dedicate any of its assets to Aphria stock.

Company Horizons Marijuana Life Sciences Index ETF AdvisorShares Pure US Cannabis ETF Global X Cannabis ETF
Aphria (NASDAQ:APHA) 21.6%   9.9%
Canopy Growth Corp. (NASDAQ:CGC) 13.5%   5.4%
Innovative Industrial Properties (NYSE:IIPR) 8.1% 4.6%  
Green Thumb Industries (OTC:GTBIF)   11%  
Cresco Labs (OTC:CRLBF)   9%  
Trulieve Cannabis (OTC:TCNNF)   11.5%  
Curaleaf Holdings (OTC:CURLF)   11.3%  
Cronos Group (NASDAQ:CRON) 10%   6.1%
GW Pharmaceuticals (NASDAQ:GWPH) 10.7%   9.1%
Aurora Cannabis (NASDAQ:ACB)     5.6%
Tilray (NASDAQ:TLRY) 8.7%   8.5%

Data source: Horizons ETFs, AdvisorShares, Global X ETFs.

Below are a few examples of how various investors would use the table above to reference the data, and form a decision based on the information.

Investor No. 1 is Steve. Steve's own research has brought him to the conclusion that he likes Green Thumb Industries and Cresco Labs, while also acknowledging that Innovative Industrial Properties has shown success in its sale lease-back program to support real estate capital for the medical-use cannabis industry. Based on these three stocks, combined with his interest in a pure U.S. play, a solid ETF for Steve to explore is AdvisorShares Pure U.S. Cannabis. 

Investor No. 2's name is Jenna. Jenna's research has led her to Aphria, Innovative Industrial, and Cronos Group. The right ETF for Jenna to invest in might be Horizons Marijuana Life Sciences. By doing so, she gets an ETF with three of its top four holdings meeting her needs, which also represents almost 40% of its total asset weight.

Let's call investor No. 3 Nathan. Nathan wants in on Aphria, Canopy Growth, Aurora Cannabis, and Tilray. He is also aware of the proposed merger of Aphria and Tilray. The best bet for him is Global X Cannabis ETF. Choosing Global X will get him four of its top five favorite stocks, which make up about 30% of its total weight.

All have selected individual stocks that have potential, but it gives the investor single-source risk in each area of focus if invested in individually. In order to minimize this risk, choosing a best fit ETF covers all bases with a single source investment.

The trade-offs of ETF investing

In any of the scenarios above, the growth potential of each stock remains, though it may be a bit watered down via the inclusion of multiple stocks in an ETF. However, it also minimizes the risk of investing in those three to four individual stocks alone, while also providing a possible stock that may not have been on your radar, and could be the next to take off unexpectedly.

Rumors are swirling around potential mergers and acquisitions (M&A) in the industry (Tilray and Aphria announced a merger on Dec. 16, 2020), and we as individual investors are usually the last to know. However, an ETF manager, whose job it is to keep a close eye on these investments, may be quicker to learn of such activity and take asset allocation action as necessary.

Great for the new cannabis investor

If you're interested in the growing cannabis market, but simply don't have the time to research individual stocks, an ETF could work for you as well. And the method of digging deeper into asset allocation could help investors understand which companies the ETF managers think will produce results.

Investing in stocks always comes with a level of risk. If you've got your mind set on investing in the cannabis market and realize that it's still early in the game, investing in an ETF can give you exposure to this budding market without the risk of individual stock price swings, until we all find out who the real leaders are going to be. It also gives us some time to see if the Biden administration will work toward decriminalization in the U.S.

As with any investment, it is always best to do your due diligence. And when it comes to ETFs, setting your top individual stocks against how various ETFs have allocated their funds is a great place to start. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.