Trading marijuana ETFs isn’t always easy—or cheap.
We first reported on the issue of persistently wide spreads in marijuana ETFs months ago, specifically in the context of the ETFMG Alternative Harvest ETF (MJ), which was for a very long time the only pure-play fund in the space (read: „Large, Liquid ETFs With High Spreads„).
Since that article was published, several other cannabis ETFs have launched. Notably, each exhibits the same wide spreads as MJ—or, in some cases, much wider:
Sources: ETF.com, FactSet; data as of Aug. 8, 2019
[Author’s Note: Due to incomplete data from FactSet, the Amplify Seymour Cannabis ETF (CNBS) is not included on this list or in this analysis. The actively managed fund, which began trading on July 23, has $3.68 million in assets under management.]
The reasons behind marijuana ETFs' wider spreads are varied and complex, including higher-than-average sector volatility; illiquidity of marijuana securities, many of which are microcaps and/or domiciled overseas; and continued reticence on the part of authorized participants (APs) and market makers to handle securities of uncertain legality.
In some cases, though, certain quirks of the individual ETFs themselves may be influencing spreads as well.
Higher Spreads Than Other Thematic Funds
Wide trading spreads are possible, but not necessarily common in thematic ETFs. Plenty of other popular thematic funds about the same cap size as MJ tend to trade with much narrower spreads.
For example, the Global X Robotics & Artificial Intelligence ETF (BOTZ), the leading artificial intelligence ETF, trades with a 0.05% spread. The Invesco Water Resources ETF (PHO) has a spread of 0.07%:
Source: ETF.com; data as of Aug. 8, 2019
The difference between marijuana and these other themes is the underlying market, which, in the case of cannabis, is extremely small, volatile and illiquid. Not only are marijuana stocks still illegal in the U.S. at the federal level (though most are legal in the state(s) in which they operate), most are still relatively new launches and are characterized by small market capitalizations, thin trading volume and whipsawing price action.
Furthermore, the vast majority of legal cannabis stocks are foreign-domiciled, primarily in Canada. Discrepancies in market hours between the U.S. and foreign exchanges, as well as additional processes required to trade/settle international stocks, can make it harder to buy and sell foreign cannabis companies at competitive prices, thus further reducing liquidity.
„A lot of marijuana stocks aren’t very liquid. Even though they trade a lot, the flow is low,” said Mark Esposito, president of Esposito Securities, a leading market making firm with experience trading in and acting as AP for cannabis ETFs. „Because of that, people are afraid to trade them, so there’s not a whole lot of quotes.”
Even though there are more and more cannabis companies doing initial public offerings every day, the overall market remains relatively small in size and capitalization, he adds.
„There aren’t enough stocks to really keep the market afloat,” explained Esposito. „Everybody’s buying the same names, which is hyperinflating the individual stocks, making them more volatile.”
Difficulties Creating & Redeeming Shares
All this has real consequences at the ETF level. When APs—the financial institutions whose job is to create and redeem new shares of an ETF by buying/selling shares of the underlying stocks—find it difficult to procure the securities they need, they’re discouraged from supporting that ETF.
On top of that, many of these institutions were already reticent to hold cannabis stocks, given their still-uncertain legality at the federal level.
As a result, it isn’t unusual for cannabis ETFs to have a limited number of available APs. For example, ETFMG recently stated it had four APs supporting MJ, while THCX has just one. In contrast, many core ETFs have 10 APs or more signed to support a fund.
Fewer APs means less competition when it comes time to create and redeem shares, meaning wider trading spreads for the end user.
„The market makers have to play it safe and keep a larger spread,” noted Esposito. „And if there aren’t as many market participants, they can have larger spreads and make larger margins. So it becomes a self-fulfilling prophecy.”
Does Passive Make For Easier Trading?
Notably, the two passively managed marijuana ETFs, MJ and The Cannabis ETF (THCX), trade with spreads roughly half as wide as those of the actively managed AdvisorShares Pure Cannabis ETF (YOLO) and the Cambria Cannabis ETF (TOKE).
MJ and THCX have average trading spreads of 0.24% and 0.22%, respectively; while YOLO and TOKE respectively have spreads of 0.44% and 0.40%.
Matt Markiewicz, founder of Innovation Shares and portfolio manager for THCX, attributes passive management for THCX’s 0.22% spread, which is the tightest of the four ETFs examined.
„Market makers have more comfort we’re not going to pull out of our positions frequently and their hedge is going to be left exposed,” he said.
Trading Volume Is Paramount
However, active management alone shouldn’t necessarily result in higher trading spreads for ETFs. The more likely culprit here is trading volume—”generally the single biggest factor correlated to spread,” said ETF.com Managing Director Dave Nadig.
MJ and THCX trade substantially more volume day to day than either YOLO or TOKE. Average volume for MJ and THCX is $12.7 million and $2.3 million, respectively.
For YOLO and TOKE, though, average volumes are respectively $1.2 million and $0.4 million.
Given that TOKE is still a new ETF—it launched on July 25—its relatively higher spread is likely directly the result of its low volume.
In YOLO’s case, which has been on the market for four months and has respectable trading volume above $1 million, another root cause may be contributing.
Swaps Contracts To Obtain Exposure
As actively managed funds, both YOLO and TOKE may invest in derivative contracts, a feature that YOLO has used to substantial impact by investing in the swaps contracts of multistate operators (MSOs).
MSOs are marijuana companies operating across multiple U.S. state lines. While their business activities are legal in the states in which they operate, these companies technically remain illegal at the federal level—meaning, among other things, their equities are ineligible to be listed on national stock exchanges.
YOLO is the first, and so far the only, ETF to obtain exposure to MSOs and other companies of uncertain legality through the use of swap contracts. (Swaps are derivatives in which one party agrees to exchange (“swap”) the value or cash flow of a given asset for another. Also see “How Do Swaps Work?”)
„[The use of swaps contracts] removes the actual, direct ownership, which is the real hangup for all nonallowed cannabis stock,” said Dan Ahrens, COO of AdvisorShares and YOLO’s portfolio manager.
Swaps Can Add Illiquidity
Generic listings standards allow actively managed ETFs to use a certain level of these derivatives, but obtaining swaps contracts can be expensive and difficult, since it requires venturing into the over-the-counter markets.
Swaps are written on a customized basis for nonstandardized amounts and terms, and must be traded via margin accounts. Due to the increased difficulty in procuring them, ETFs using swaps tend to possess higher trading spreads.
Furthermore, little is publicly available about the particular swaps contracts YOLO uses, which, as of Aug. 9, comprise 17.2% of its portfolio. It is unclear how liquid they are or who their counterparties may be, or what would happen should they default on their agreements.
‘Very Large, Very Liquid’
Ahrens declined to comment on the counterparties or other specifics of YOLO’s swaps contracts, instead stating that, „Any stock we’re getting exposure to through a swap is still an exchange-listed stock; very large, very liquid.”
Some of the swaps YOLO uses are indeed for „very large, very liquid” stocks, such as Cresco Labs, which has a $135 billion market capitalization.
However, YOLO also uses the swaps of smaller companies, like Trulieve Cannabis, which has a market cap of $1.1 billion, or Ianthus Capital Holdings, which has a market cap of $231 million.
Still, added Ahrens, „We are being selective about which [contracts] we’re adding. We want access to most of the biggest and the best.”
Unusual Create/Redeem Process For MJ
But what about MJ, the oldest and largest marijuana ETF, and the fund that sparked this investigation so many months ago? Interestingly, MJ possesses its own potentially complicating set of circumstances surrounding creation/redemption; yet, according to the data, its unique setup appears to have had little concrete impact on its spread.
To create and redeem shares of an ETF, APs generally rely on what’s known as a portfolio composition file (PCF), which tells them which securities to buy/sell and in what amounts. Updated on a daily basis, PCFs are uploaded to the National Securities Clearing Corporation (NSCC)’s website and made available for APs to download. The vast majority of ETFs participate in this process.
ETFMG, though, does not post its PCF to the NSCC website; it hasn’t for nearly a year, not since it suddenly switched its custodian and transfer agent to Wedbush Securities and Computershare Trust Company, respectively (read: „Marijuana ETF Shifts Custody„).
Instead, MJ’s PCF is available for download only on the fund’s website, under the tab labeled „Basket.”
Transfer Agent Not NSCC Member
Given how many of the securities in MJ overlap with those in YOLO, THCX and TOKE—all of which post their PCFs to the NSCC website—the motivation behind not posting MJ’s PCF is likely not the underlying securities.
Instead, it may have to do with the fact that MJ’s transfer agent, Computershare, is still not a listed member of the NSCC. Transfer agents are the fund servicers responsible for processing the actual creation/redemption of new ETF shares, as well as maintaining records of creation/redemption activity. They are also usually the party that uploads the PCF to the NSCC.
We first reported on Computershare’s lack of NSCC membership last September (read: „Strange Case Of Premiums For Pot ETF„). It appears that the company still has yet to obtain NSCC membership, as of the August member update.
Neither the NSCC nor Computershare immediately returned requests for comment. Wedbush Securities, MJ’s custodian, declined to comment on this article.
MJ: Trading Spreads Still Relatively Narrow
Regardless, the unorthodox method in which ETFMG makes MJ’s basket available to APs does not seem to have hurt its trading spreads. MJ has the second-lowest trading spreads of the four cannabis ETFs examined.
Despite initially responding to request for comment, ETFMG did not respond in time for publication. We will update this article when we hear more.
„They do things a little differently,” said Esposito, who was the previous owner of ETFMG, and has worked with the firm closely since its sale. „They did that in order to grow [the ETF] and to take it off U.S. Bank’s platform and onto Wedbush’s. I’m not an expert on the nuance, but clearly it’s worked.”
Contact Lara Crigger at [email protected]