Marijuana ETF: 26 Risks You Need to Know About

The trend toward marijuana legalization has gained a lot of momentum in recent years, and the recent decision from California to legalize marijuana for recreational use was a monumental event for proponents of legal pot. Although a lot of attention has focused on new options for users of marijuana, many see the budding industry as a potential cash cow and have sought ways to invest in its financial success.

Late last month, the ETFMG Alternative Harvest ETF (MJX 3.67%) became the first marijuana-focused exchange-traded fund to have its shares listed on the New York Stock Exchange's NYSE Arca exchange. Money has quickly flooded into the fund, but even the ETF provider itself acknowledges that there are substantial risks involved. Below, you'll find a summary of all the risk factors that ETFMG disclosed in its prospectus from December. Although they're specific to the ETFMG fund, many similar risks will exist with other marijuana ETFs when they become available.

The risks of the Alternative Harvest ETF

Here's what ETFMG has to say about the risks of its marijuana ETF.

1. Possession and use of marijuana, even for medicinal purposes, is illegal under federal and certain states' laws.
2. No drug product containing natural cannabis or naturally derived cannabis extracts have been approved by the U.S. Food and Drug Administration for use in the U.S. or obtained Drug Enforcement Administration registrations for commercial production.
3. Facilities conducting research, manufacturing, distribution, import/export, or dispensing of controlled substances must be licensed and meet DEA guidelines to prevent drug loss and diversion.
4. Various laws exist outside the U.S. that could prohibit marijuana-related activity, and even if laws allow such operations now, they could change adversely in the future.
5. Marijuana companies face intense competition.
6. Access to banking services for marijuana companies is limited in some jurisdictions.
7. Litigation and enforcement action activity could take away from marijuana companies' capacity to focus on operations.
8. The ETF's high level of concentration increases the risk of loss for investors.
9. More broadly, many marijuana companies would qualify as part of the consumer staples sector, and that sector is subject to risks like changing demographics, spending habits, and product preferences.
10. Like any other stocks, marijuana stocks are exposed to general risks of the stock market.
11. Fund investments in foreign marijuana stocks expose the ETF to currency risk, depositary share risk, foreign market and securities trading concerns, and political and economic risk.
12. The healthcare companies in which the fund invests are subject to extensive government regulation and litigation risk irrespective of their focus on marijuana.
13. There's no guarantee that an active trading market for ETF shares will develop.
14. ETF shares could trade above or below the net asset value of the investments that the fund holds.
15. Investors are responsible for any costs of buying or selling ETF shares that are imposed by brokerage companies, as well as potentially wide bid-ask spreads.
16. The marijuana ETF is new and might not grow to an economically viable size.
17. Even though the focus of the ETF is on marijuana, the companies in which it invests have non-cannabis related businesses, and difficulties with those businesses could hurt the value of the investment even if the marijuana business does well.
18. The ETF follows a passive investment strategy and isn't actively managed.
19. Concentration of fund assets on Canadian companies exposes the ETF to risks specific to Canada, including economic and trade-related factors.
20. The ETF also invests in European companies, and economic conditions in Europe carry risk.
21. The ETF generally invests in small companies that have higher price volatility, less active trading, and difficulties in taking large share positions without having a direct impact on stock prices.
22. The fund might not reap the favorable tax benefits of being a regulated investment company.
23. The ETF might not accurately track its benchmark index.
24. Sale prices for fund investments might differ from the fund's benchmark's valuation for those investments.
25. The ETF has a limited number of authorized participants, market makers, and other providers of liquidity, and that could hamper trading.
26. The fund's real-time provision of portfolio value estimates could be flawed and could inaccurately reflect current net asset values of ETF investments.

Which marijuana ETF risks should you worry about?

Out of these 26 risks, the biggest one is the uncertainty in the current patchwork of legislation that covers the marijuana industry right now. As the ETF goes into more detail on, marijuana is still a schedule I controlled substance in the U.S. under the Controlled Substance Act and therefore illegal under federal law. Although more than half of states plus the District of Columbia have laws that recognize legitimate medical uses for cannabis and allow for consumers to have access to marijuana either for medicinal or recreational use, there are still a substantial number of states where it's still illegal.

Moreover, the ETF admits that federal law pre-empts state law, and calls from Attorney General Jeff Sessions to enforce federal anti-marijuana laws could destroy the ability of cannabis companies in the U.S. to do business even in states that are friendly to marijuana.

The other key risk to consider is that most of the companies specializing in cannabis-related activity right now are small, subject to intense competition, and vulnerable to external shocks. That's one of the reasons why cannabis stocks can produce such impressive gains when things go well, but if conditions deteriorate, the stocks could take a big hit that would bring the ETF share price down with them.

Know the risks

Investing in marijuana is a high-risk proposition, with great potential for rewards. Exchange-traded funds offer a more diverse set of marijuana companies in which to invest through a single vehicle, but that doesn't mean that marijuana ETFs eliminate the risks involved in investing in this high-growth industry.