Remember when cannabis-focused exchange-traded funds were all the rage and generated tons of excitement? Seven of the nine exchange-traded products (two are exchange-traded notes) in this space came to market in 2019 amid a lot of hype, but five of the six products with one-year track records have registered losses ranging from 29% to 47% during that period.

The exception among them is the AdvisorShares Vice ETF (ACT), which was up nearly 13%. But this fund is a different animal in that only about 40% of its portfolio is exposed to companies with significant cannabis-related revenue. Other sectors in this fund—specifically, alcohol and tobacco—have provided a buffer against the vicissitudes of the marijuana market.

The point is that the cannabis industry has been a downer for investors. Why? Well, let’s count the ways.

According to various published reports, the reasons include lower-than-expected demand in the legal recreational market while black-market sales thrive, particularly in Canada, which legalized recreational pot nationally in October 2018 but has subsequently experienced an uneven rollout across the country. And many big-name companies in this industry have experienced rising operating costs, falling margins and depleted cash reserves, which has turned off investors.

Elsewhere, and this is a biggie, a cloud of regulatory uncertainty hangs over the cannabis industry. In the U.S., medical marijuana is legal in 33 states and the District of Columbia, and recreational weed is legal in 11 states and in D.C. But the U.S. government classifies cannabis as a Schedule 1 drug (i.e., those having no currently accepted medical use and a high potential for abuse). As such, banks are wary about doing business with companies involved in cannabis, making it hard for companies to get funding. And some custodians are leery about letting their customers trade stocks whose operations run afoul of federal law.

Add it up, and it seems like daunting days for the cannabis industry, which makes this week’s launch of the actively managed AdvisorShares Pure US Cannabis ETF (MSOS) seem like a contrarian move. Or worse, ill-timed. But the fund’s portfolio manager, Dan Ahrens, posits that the cannabis trade oozes with potential and that investors have focused too much on Canada’s cannabis problems while ignoring the vast potential of the U.S. market. The MSOS fund is the first pot ETF geared specifically toward companies serving the U.S. market.

“There are a lot of tailwinds for U.S. cannabis,” Ahrens said. “The U.S. market is at least 10 times the size of the Canadian market. Single states like Colorado and California and Illinois are each on their own a bigger market than Canada.”

Another potential plus for the U.S., he added, is the widely expected belief that additional states will come online in the next year after the November election.

“States that don’t currently have legal marijuana sales might be adding medical marijuana, and states that have medical marijuana now might be moving to recreational use,” Ahrens said. “That’s potentially a huge market upside.”

The MSOS fund invests in the securities of—or uses derivatives tied to—companies that derive at least 50% of their net revenue from the marijuana and hemp business in the U.S. The fund’s net expense ratio is 0.74%.

Cutting Through The Hype
Ahrens is no stranger to the cannabis sector. He’s the portfolio manager of the aforementioned AdvisorShares Vice ETF, which launched in late 2017, as well as the AdvisorShares Pure Cannabis ETF (YOLO) that began trading in April 2019. Both are actively managed, and whereas the former is intended to be a mix of cannabis, alcohol and tobacco companies (the latter two sectors are deemed as less-volatile dividend plays meant to add ballast to the portfolio to counteract the volatility of the cannabis sector), YOLO was the first actively managed ETF to invest solely in cannabis-related companies. All of its holdings are listed in either the U.S. or Canada. That includes overseas companies, such as U.K.-based GW Pharmaceuticals, that trade in this country as an American depositary receipt.

In fact, YOLO was just the second U.S.-listed ETF focused on marijuana. The first was the ETFMG Alternative Harvest ETF (MJ), an index-tracking product that converted from an existing Latin America real estate fund into a cannabis fund in December 2017. 

According to its prospectus, the fund’s underlying index excludes companies whose business activities are legal under state cannabis laws but not legal under federal cannabis laws. The types of businesses that can be included in the portfolio range from pharmaceutical companies to those that aid in the legal cultivation of cannabis.

Other ETFs in this category take a similar tack, giving them significant exposure to large Canadian growers that might be U.S.-listed but which serve the Canadian market only, not the U.S. medical or recreational market. And some of these companies have stumbled for various reasons since they made splashy debuts on the public market.

“The mainstream media and individual investors have been way too focused on the Canadian market and on the big four in Canada comprising Canopy [Growth], Tilray, Aurora [Cannabis] and Cronos [Group],” Ahrens said. “All four of those are wildly unprofitable.”

He posited that when the cannabis craze was in full bloom during late-2018 and early-2019, cannabis stocks traded too much on hype and future expectations rather than on their financials, balance sheets or their ability to become profitable.

“With cannabis, investors need a lot more awareness and education that not all cannabis investments and cannabis ETFs are created equal,” Ahrens said, adding that other ETFs are missing the boat by ignoring companies that operate in the U.S.

“That’s why we launched a new fund, MSOS, that’s U.S.-only focused,” he said.

Regulatory Balancing Act
But launching the fund wasn’t easy due to the regulatory tightrope that comes with trying to invest in companies serving the U.S. market. Last August, AdvisorShares initially filed with the Securities and Exchange Commission for approval for the AdvisorShares Pure US Cannabis ETF, which then had a different ticker symbol, MJUS.

The sticking point was that this fund, now trading under the MSOS ticker, gets exposure to the U.S. cannabis market via multistate operators, or MSOs, which are U.S.-based companies directly involved in the legal production and distribution of cannabis in states where it's approved. Leading companies in this space include Curaleaf Holdings, Green Thumb Industries, Trulieve Cannabis and Cresco Labs.

As Ahrens explained, the listing requirements at the major North American exchanges—the NYSE and the Nasdaq in the U.S., and the Toronto Stock Exchange and the TSX Venture Exchange in Canada—require that a company be legal in all places they operate whether on a state, provincial or federal level.

As such, the patchwork U.S. legal system regarding cannabis makes MSOs verboten to these major exchanges. Instead, these MSOs, some of which are multi-billion dollar companies, are relegated to trading on the OTC market in the U.S. and/or on the Canadian Securities Exchange, an electronic alternative stock exchange for micro-cap and emerging companies.

“It took a great deal of behind-the-scenes work to get this fund approved,” Ahrens said. “The SEC asked us to get a third-party legal opinion written specifically for how this fund would invest, and we provided that. And the NYSE (MSOS is listed on the NYSE Arca exchange) lawyers pushed a rule filing amendment with the SEC specifically for how this fund would invest, and it took time to get that order granted.”

In short, the MSOS fund doesn’t invest directly in U.S.-based MSOs. As noted by Ahrens, the legal opinion obtained by AdvisorShares, along with what’s stated in the fund’s prospectus, stipulate that MSOS can invest directly only in the equities of companies listed on the four major exchanges mentioned above.

Instead, the fund uses swap options to obtain indirect exposure to MSOs. Swaps are derivative contracts where two counterparties agree to exchange or swap payments regarding stocks, interest rates or commodities.

As of now, eight of the top 10 holdings in the MSOS fund involve swaps. Ahrens said the swaps aren’t leveraged, so they don’t add risk to the fund in that regard.

“There’s counterparty risk whenever you use a third-party contract, but it’s important to realize we’re getting exposure to total return swaps in a one-to-one ratio,” he said. “If I’m getting exposure to $1 million in Curaleaf, for example, we have $1 million in cash to cover that.”

Ahrens also employs swaps to invest in MSOs in the YOLO fund, and he noted that this practice differentiates these two funds from their rivals. As such, he believes, this helps explain why YOLO has been the best-performing ETF among those primarily focused on cannabis.

Granted, this outperformance is on a relative basis: YOLO is up 2.4% year to date, while the MJ fund and products from Amplify ETFs, Cambria, Global X and Innovation Shares are down roughly 10% to 36%, depending on the fund. The year-to-date return on S&P 500 Index is 6.9%.

On a one-year basis, YOLO has fallen 29%, while the other ETFs in the cannabis group have lost more than 40%. (This analysis doesn’t include the two ETNs in this category, which follow a different structure). The S&P 500 is up almost 19% during the past year.

“YOLO is outperforming for two reasons,” Ahrens said. “One is active management. We’re picking the right stocks at the right time better than an index can, in my opinion. The other reason relates to our U.S. exposure in that we’re the only fund with exposure to those MSOs."

And the new MSOS fund will have greater exposure to MSOs, making it a more expansive entrée to the U.S. market. Which begs the question whether MSOS makes YOLO superfluous.

Ahrens, of course, doesn’t think so. “YOLO has some global exposure combined with U.S. exposure. MSOS is 100% U.S.-focused. That provides diversification within one’s cannabis exposure.”

He envisions any cannabis fund to be a growth-oriented satellite position within the equity portion of an investor’s portfolio. But given the rough going so far in the cannabis patch, investors can’t be blamed for being skeptical about the industry’s much-promised growth potential.

“There’s no denying in the second half of ’19 into the early months of ’20 that the entire group of cannabis stocks was down dramatically,” he said. “This is a very new industry with lots of volatility that’s regulatory related. But maybe the selling was overdone, and these stocks were severely shorted across the board.”

Indeed, the sector has rebounded—as has the rest of the U.S. equity market—since its nadir in late March. Is this a case of the proverbial high tide lifting all boats, or does the pot trade have staying power?

Ahrens expects the outlook in Canada to improve as the country opens more retail outlets for recreational weed. And he and others are bullish on the prospects of greater marijuana legalization in states across the U.S.

Investors have heard that line before, but it does appear the cannabis legalization train in the U.S. will inevitably pick up speed, and that could benefit investors with a long-term outlook.