The rise of the marijuana industry over the past several years has been monumental, and 2018 in particular was groundbreaking for cannabis-related businesses. After watching for years as individual U.S. states legalized marijuana one by one for various purposes, the entire nation of Canada took a great leap forward by making recreational cannabis legal across the country in mid-October. Gradually, more jurisdictions across the globe have decided to eliminate laws against marijuana, and the movement seems to be gaining even more momentum in 2019.

Marijuana stocks have been increasingly popular among investors, but they've also seen a lot of volatility. Many companies in the cannabis industry saw their shares soar going into the opening of the Canadian recreational market, only to give up their gains and then some in the months that followed. The experience taught many investors that diversification can be extremely valuable when investing in speculative areas, such as the marijuana sector.

Exchange-traded funds (ETFs) have solved this problem in many other areas of the market, and although there are a limited number of marijuana ETFs right now, those that are available offer wide exposure to many of the biggest players in the budding industry.

Below, we'll look at the top marijuana ETFs. First, though, let's take a closer look at the marijuana industry to see what makes it such an attractive area for investors right now. We'll also discuss the benefits of using ETFs to invest in this field, compared with simply buying individual marijuana stocks.

Growing facility with lights and a vast field of cannabis plants growing.

Image source: Getty Images.

Why the marijuana industry is red-hot -- and getting hotter

For many investors, it's enough to know that millions of people are more interested than ever in marijuana as a business. Countless stories about the great success being experienced by some early pioneers in cannabis have whetted the appetites of those who'd like to share in the positive prospects of the fast-growing industry.

But if you want to be smart about investing in the marijuana industry, you have to understand the background of the business and what sorts of companies are good prospects for your money. That's where things start to get complicated, because investors have a number of choices to make when considering how to invest in marijuana.

First, you have to decide how narrow -- or broad -- your definition of a marijuana stock is. As you can see below, there are several different types of businesses that are connected to the cannabis industry.

  • Growers: The most direct way to invest in marijuana is to buy shares of companies that specialize in cultivating and growing cannabis plants. These pot growers include some of the best-known stocks in the industry right now, such as Canopy Growth (NASDAQ:CGC), Aurora Cannabis (NASDAQ:ACB), and Tilray (NASDAQ:TLRY). Some cannabis cultivators focus on making their products available for healthcare purposes under medical marijuana regulations, while others have sought to break into the newer recreational market. These businesses are also seeking partnerships with companies that are not in the marijuana business, such as Canopy's major deal with beer and spirits giant Constellation Brands (NYSE:STZ).
  • Derivative players: Some companies don't grow marijuana, but they do use some of the ingredients contained in cannabis plants for their own purposes. For example, New Age Beverages (NASDAQ:NBEV) is working to develop cannabis-infused drinks, following in the footsteps of many larger consumer giants that have created partnerships with marijuana producers. Drug companies such as GW Pharmaceuticals (NASDAQ:GWPH), meanwhile, are exploring the medicinal qualities of various compounds found in cannabis in the hope of finding treatments that are superior to those available elsewhere in the pharmaceutical industry.
  • Support specialists: Still more companies are focused not on cannabis or its contents but on providing the goods and services needed by marijuana cultivators and their end users. For instance, cannabis growers that want to rent industrial space for their greenhouses might work with real estate investment trust Innovative Industrial Properties (NYSE:IIPR), which specializes in locating and leasing out such properties. Similarly, to comply with packaging regulations in many jurisdictions, a grower might work with KushCo Holdings (OTC:KSHB), which has direct, relevant expertise in helping a wide array of customers comply with legal requirements. And well-known plant food and fertilizer company Scotts Miracle-Gro (NYSE:SMG) has created a division dealing specifically with the hydroponic technologies used by many marijuana growers.

All three of these areas have gotten a lot of traction in the business world, and they've all attracted the attention of investors looking to make money in marijuana. Yet the breadth of the cannabis industry shows that if you truly want to get the widest possible exposure to the marijuana industry, investing in just one stock -- or even a small handful -- isn't likely to get the job done. That's where marijuana exchange-traded funds come in.

The benefits of investing in cannabis ETFs

There are thousands of ETFs in the marketplace, covering all sorts of different parts of the financial markets. These are pooled investment vehicles that allow thousands or even millions of investors to own shares in a large basket of investments that typically share some common trait. Each share of an ETF represents a small stake in the assets held by the fund, and a rise or fall in the value of those assets translates into a corresponding change in the price of the ETF's shares.

Each ETF is designed with a specific investment objective in mind. Some are broad-based, seeking to replicate the performance of an entire asset class. For instance, one of the biggest ETFs covers all 500 stocks in the S&P 500 Index. Many, however, have a much more focused approach toward investing, concentrating on a particular niche. It's this second category that marijuana ETFs fall into, given the small number of cannabis companies in comparison with the stock market as a whole.

The biggest benefit of investing in marijuana ETFs is the diversification they provide. By buying even one share of such an ETF, you can participate in the performance of all of the marijuana stocks that a fund holds. It would take a lot more investment capital to build an individual stock portfolio with that much diversification. Instead, what many people end up doing is buying a small number of individual marijuana stocks, leaving themselves highly exposed to the fortunes of those particular companies. As a result, if something bad happens to those stocks but does not affect the entire cannabis sector, these investors are at risk of big losses even if the marijuana industry as a whole is doing well.

Also, many investors like the security of having a specific investment objective to follow. As you'll see below, different marijuana ETFs have different objectives, and that makes their holdings quite different as well. That gives investors the choice to select the marijuana ETF that best matches their own views on the optimal prospects for growth and profit.

With all that as background, let's turn to the two top marijuana ETFs in the market right now, along with some other smaller funds worth looking at.

The two top marijuana ETFs

Marijuana ETF

Assets Under Management

1-Year Return

ETFMG Alternative Harvest (NYSEMKT:MJ)

$1.25 billion


Horizons Marijuana Life Sciences (TSX:HMMJ) (OTC:HMLSF)

$740 million


Data sources: Fund companies, Yahoo! Finance.

The leading marijuana ETF for U.S. investors

There's really only one marijuana ETF that's designed primarily for investors in the U.S. to use. The ETFMG Alternative Harvest ETF adopted a marijuana-focused investment objective in late 2017, and since then, it has invested in companies that have business models with at least some connection to the cannabis industry. That's given Alternative Harvest the ability to invest in all the categories of marijuana stocks listed earlier in this article, including cannabis cultivators, providers of ancillary products and services for cannabis-company clients, and pharmaceutical companies looking to take advantage of the promising medical attributes of cannabis in developing possible treatments.

Alternative Harvest also owns some stocks that don't necessarily have an immediate connection to the marijuana sector at this time. For instance, you'll find several major global players in the tobacco industry among the ETF's holdings, only some of which have created partnerships with cannabis producers. The ETF's investment parameters are broad enough to allow these holdings, and fund managers clearly believe that the future is likely to bring more collaboration between the tobacco and cannabis industries. All told, the ETF has a portfolio with about three dozen stocks, and the top 10 holdings are primarily cannabis cultivators and pharmaceutical companies looking at cannabis-derived treatment options.

From a performance perspective, Alternative Harvest had a tough year in 2018. Investors were excited coming into the year, but most of the stocks in the ETF's portfolio lost ground in an increasingly difficult environment across the broader stock market during the early months of 2018. Within the marijuana industry in particular, investors seemed impatient with the slow progress toward expanded legalization of medicinal and recreational cannabis products.

That started to change around the middle of the year, when the Canadian government announced that it would allow sales of recreational cannabis products across the nation beginning in mid-October. Marijuana stocks didn't immediately jump higher, but as the legalization date approached, investors started paying closer attention to the cannabis industry, and Alternative Harvest saw substantial gains -- at its peak, the ETF was reflecting about a 30% year-to-date gain.

That high proved short-lived, however. Once the mid-October date had passed and the Canadian cannabis market was open for business, many investors seemed dissatisfied with the early results and the challenges that arose. Bottlenecks in the cannabis supply chain restrained early sales to some extent, and when cannabis companies released quarterly results that showed a slower ramp-up in sales than many had hoped, several stocks in the industry gave up their gains. That's what eventually led Alternative Harvest to losses of about 23% for 2018.

Yet 2019 has started out well for this ETF, with the share price having jumped almost 50% in just the first three months of the year. Optimism about major cannabis producers has been the primary catalyst for the gains, and since the top four Canadian marijuana industry players make up more than 35% of the fund's holdings, their strong performance has translated into big share-price appreciation for Alternative Harvest as well. Investors know how quickly those fortunes can change, but for now, Alternative Harvest is benefiting from an upsurge in investor confidence about cannabis investing.

Horizons Marijuana Life Sciences ETF

Horizons Marijuana Life Sciences ETF has a similar investment objective to ETFMG Alternative Harvest. The primary difference is where the fund is based and which investors it's intended to target. Horizons is a Canadian ETF provider based in Toronto, and its family of exchange-traded funds is listed on the Toronto Stock Exchange. Marijuana Life Sciences shares aren't registered with the U.S. Securities and Exchange Commission, and they don't trade on major U.S. exchanges, although they are available to U.S. investors on the over-the-counter market.

The Horizons marijuana ETF has a larger number of individual holdings than Alternative Harvest, numbering close to 50. However, the Horizons portfolio is a bit more top-heavy, with just seven stocks accounting for more than 65% of the fund's total assets. Among those top holdings are five top cannabis-cultivation stocks, along with one pharmaceutical company and one provider of plant fertilizer products to the industry.

Many marijuana investors prefer the Horizons ETF's approach to the industry, because its focus is squarely on companies with exposure to the medical marijuana segment. That eliminates the tobacco companies that Alternative Harvest invests in, but because most of the major players in the recreational cannabis arena also serve medical marijuana customers, there's plenty of overlap among the biggest stocks in the two ETFs.

Despite the differences in the two portfolios, the Horizons ETF's ups and downs during 2018 very closely mimicked the performance of Alternative Harvest. Losses during the first half of the year gave way to a brief surge heading into September and October, but those gains disappeared in November and December. The Horizons ETF has also put up impressive performance during the first part of 2019, riding the wave of interest in the marijuana growers that headline its holdings list.

The risks of cannabis investing and marijuana ETFs

Marijuana has been a hot area for investors lately, and that's created some dangers for the unwary. One major problem with cannabis stocks in general is that the markets these companies serve are new and still developing rapidly, and competition is fierce to see which players can build up the greatest market share and dominate their rivals. Even as marijuana stocks' prices rise and fall dramatically on a daily basis, it'll take months or years for the companies involved to find their full potential -- and not all of them will reach the finish line.

There's also plenty of room for bad behavior. Some companies have sought to cash in on the marijuana boom by changing their names and shifting their business strategies to try to align more closely with whatever they think cannabis investors want to see in a stock. Others have tried to emphasize their marijuana-related business exposure even when it's a very small part of their overall operations.

Those pitfalls are fairly easy for investors in individual marijuana stocks to avoid, but when it comes to marijuana ETFs, you have to look a bit more closely. The investment strategies that marijuana ETFs follow are designed to offer exposure to a wide range of stocks involved in the cannabis industry, and they don't necessarily weed out some of the companies that might not pass your own personal smell test when it comes to marijuana investing. 

Moreover, marijuana ETFs are relatively expensive. Both the ETFMG and Horizons marijuana ETFs charge investors 0.75% of assets on an annual basis to cover expenses of their respective funds. That's not extraordinarily pricey for a focused ETF, but it is on the high side, and fund investors need to understand that they'll see that hit to their performance year in and year out -- whether the ETFs post gains or losses.

Smaller marijuana ETFs

Finally, ETF investors should be aware of some other marijuana ETFs that are in operation. Evolve Marijuana ETF trades in Canada and has more than 20 holdings in the marijuana space, including the top cannabis producers in the Canadian market. However, it has just $8 million Canadian ($5.96 million) in assets after nearly a year of being listed, showing that it's thus far failed to gain much traction among investors.

Horizons also has its Emerging Marijuana Growers Index ETF, which concentrates on the smaller companies in the cannabis space. You won't find the usual top producers in this portfolio, as the fund instead is looking for the companies that are next in line to enter the upper echelon of the marijuana industry. Again, though, with just CA$9 million in assets after nearly a year of operation, the ETF is still struggling to find a loyal investor base.

Of these two ETFs, the Horizons Emerging Marijuana Growers ETF is the more interesting, as it gives exposure that other ETFs don't offer. However, investors should be wary of investing in this small fund until it gains enough popularity to expand its share base, because ETFs with only a small amount of assets under management can be difficult to trade effectively and can lead to costly mistakes if you're not careful.

Be smart with your marijuana investments

Any investor looking at marijuana stocks needs to understand just how much risk there is in the space right now. Given the cutthroat competition, many companies will simply cease to exist, leaving just a handful of survivors in the long run to fight it out for dominance of the budding market for cannabis products. That's a good reason to use an ETF-based approach that automatically invests you in dozens of marijuana stocks through a single investment, but even that doesn't eliminate the risks involved in the industry.

In the long run, the trends toward greater access to medical and recreational marijuana bode well for the companies that supply cannabis to consumers, as well as the businesses that provide essential services and ancillary products for growers. Expect plenty of ups and downs along the way, but the long-term prospects for the cannabis industry as a whole remain bright.

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.