Cannabis ETFs? Essential Factors To Consider Before Investing

By Morgan Paxhia, Poseidon Investment Management Co-Founder

The regulated cannabis market has heated up over the past couple of years. During the pandemic, cannabis sales increased by 46%, and it is certainly not slowing down any time soon. The US legal market is expected to grow to $45 billion in 3 years according to industry data company, headset.. 

Although the cannabis sector is on the rise with more states legalizing the plant and sales increasing year-over-year, the plummeting prices of individual company stocks have given would-be investors pause. At the start of 2022, individual U.S. stocks recorded three consecutive weekly declines to kick off the year. 

In place of individual stocks, exchange-traded funds (ETFs) provide access to a portfolio of curated stocks, thereby minimizing risk through diversification. Managers can weight the different positions depending on individual company conviction. When investors buy ETF shares, they own a stake in multiple cannabis companies with one purchase. As a result, if the price of one of the stocks in the portfolio drops, it can be mitigated by other holdings. 

In addition to offsetting risk, ETFs are generally easier to trade than individual cannabis stocks. Due to the federal prohibition on cannabis, U.S. stock exchanges like the NASDAQ and NYSE don’t allow plant-touching companies like multi-state operators (MSOs) to trade on their platforms. U.S. investors interested in buying into these stocks have to work through services that allow access to US Over the Counter (OTC) or via The Canadian Securities Exchange (The CSE) markets - not astypical for American Brokerage platforms. But because ETFs are structured as investment vehicles, they can be listed on U.S. stock boards. In turn, investors can access these products on familiar platforms such as Robinhood, Equity.com, Schwabb, TDAmeritrade, etc. 

Factors to Consider Before Investing in ETFs 

Like any investment, it is prudent to research various ETFs before allocating. Similar to mutual funds, most ETFs can provide investors with a prospectus, a document that provides information about the fund's investment objectives, risks, past performance, and expenses. 

When reviewing an ETF and its prospectus, here are some key factors to keep in mind: 

1. Curation 

When choosing a cannabis (or any) ETF, you want to know what is included within the portfolio. Although there are several cannabis ETFs out there, none are the same. 

Some ETFs focus purely on cannabis companies, while others trade in hemp and CBD pharmaceuticals. Other ETFs will invest in non-plant touching companies such as real estate investment trusts (REITs) or technology or software solutions. Still, others invest strictly in

U.S.-based companies that will form the backbone of the U.S. retail supply chain when cannabis is legalized. 

Be sure to choose an ETF that you believe will maximize returns as more states open legal cannabis markets. 

2. Expertise 

There is inherent complexity and volatility in the cannabis sector. Being federally illegal poses challenges to even the most established cannabis firms. 

That’s one good reason to invest in an ETF where someone should have a watchful eye on your investment. When analyzing the management team, there are many factors to consider — years of experience and focus, background, and the type of investments they specialize in. For instance, hedge-fund managers are known to be comfortable with high-risk management strategies that maximize returns. On the other hand, investment bankers generally have a deep background in underwriting and transacting rather than portfolio and risk management. 

Consider the expertise of the management team behind an ETF and choose a team that aligns with your appetite for risk and timeline for returns. 

3. Execution 

Another reason to buy into ETFs is the various strategies that experienced management teams can utilize. Unlike regular day traders that simply buy and sell stocks, fund managers may have the ability toutilize an array of sophisticated investment strategies. 

For instance, at Poseidon we use Dynamic Leverage Capability, meaning we can be at 80% exposure to the market or go all the way up to 150% (1.5X). Then, we can manage both the portfolio and its leverage at our discretion based on various internal inputs. Early investors in cannabis have already seen larger-than-expected returns based on the beginning phases of acceleration within the industry. 

Other common ETF strategies that management teams may use include: 

● Long/Short Equity —A fund may, at times, hold both short and long positions across various asset classes 

● Merger Arbitrage — The purchase and sale of the stocks of two merging companies at the same time to create “riskless” profits 

● Global Macro — Investment decisions based on global economic trends

● Event-Driven — Strategy that capitalizes on a specific event such as a liquidation or bankruptcy 

● Distressed Debt — Buying up debts of struggling companies at a discount

Typically, an ETF’s strategy will be outlined in the prospectus. Find, research, and invest in a strategy you are comfortable with. 

The Trend Towards Cannabis Legalization is Clear 

Although federal legalization has been put on the backburner politically, the trend towards expanding access to cannabis is clear. Today there are 18 states with legalized adult use and 38 states with legalized medical use. Cannabis ETFs are a straightforward way for investors to gain exposure to this industry today for the wave of future profits from this growing industry.