The top 3 things to consider when investing in cannabis ETFs

Cannabis stocks have been climbing since the November 2020 election in the United States, when more states approved legalizing recreational cannabis. That vote and the optimism that the federal government will finally relax restrictions on cannabis and make it lawful for recreational use nationwide have caused many investors to have high hopes for the future of the industry. Furthermore, many investors saw the cannabis industry’s recognition as an essential industry during the Covid-19 pandemic as a sign of good things to come for cannabis in Washington DC.

As a result of the excellent press that cannabis is getting, many investors are rushing to add cannabis stocks to their portfolios this year. One of the cannabis securities that investors are rushing to is cannabis ETFs.

There are numerous well-performing cannabis ETFs that would satisfy the demands of many investors looking for significant gains in this very volatile cannabis stock market. However, it is critical to exercise caution when entering the cannabis stock market because of the volatility. Therefore, we’ve put together some key points to assist you on your way through the cannabis ETF marketplace.

What are cannabis ETFs?

ETFs or exchange-traded funds are funds with a collection of different stocks to minimize the downside risk for investors in the ETF. They are typically designed to track a specific index, like the S&P 500. This means that the ETF will generally behave the same way as the index it is tracking. If the index goes up, so does the ETF, and vice versa.

Although ETFs have been in existence for decades, the first marijuana ETF wasn’t established until last year. Horizons ETFs debuted on the Toronto Stock Exchange in April of 2017, tracking the performance of the North America Medical Marijuana index. This opened up a new, less-dangerous method to invest in cannabis stocks, which we want to help you take advantage of. But before we get into it, there are a few things to think about.

What to consider when investing in cannabis ETFs?

1.       What index is the ETF tracking?

This is important to know before investing in an ETF. The index that the ETF is tracking will determine both the upside and downside potential of the ETF. Furthermore, you should know the tracking difference between the ETF and the index it is tracking.

The tracking difference is the gap in performance between an ETF and the index it tracks. The trading and rebalancing expenses are generally to blame for this disparity. You may use the tracking difference as a metric to determine whether an ETF is performing well or not and whether its fees are too expensive.

Additionally, you should also know how frequently the ETF is rebalanced. Rebalancing is when the fund manager buys or sells stocks to maintain the desired weighting of the index. For example, if a particular stock in the index goes up in value, the fund manager may sell some of that stock to keep the index’s weighting constant.

The frequency of rebalancing will have an impact on both your returns as well as your costs. If an ETF is rebalanced more frequently, it will likely experience higher transaction costs. This will hurt your return, all other things being equal. You can find this information in the ETF’s prospectus.

2.       Actively managed ETF vs. passively managed ETF

The difference between recouping your investment and making a significant loss may be determined by whether or not a fund is actively managed. Actively managed funds employ humans to make decisions and execute trades, whereas passive funds utilize AI and trading bots to generate profits.

Passive funds tend to be less effective at minimizing losses than active funds. That’s because passive funds have trading cycles during which the fund’s asset composition cannot be changed even if significant losses are risked.

However, passive funds tend to have higher gains than active funds in the long term. This is because humans are not as good at making investment decisions as AI. Also, humans tend to buy and sell assets at the wrong time, incurring transaction costs that eat into returns.

So if you’re looking for immediate gains, an actively managed fund may be a better choice. However, if you’re aiming to maximize your profits in the long term, passive funds are generally a better investment.

3.       Percentage of junk stocks

It is not uncommon for funds with baskets of stocks to include some high performers and a bunch of underperformers that are there more for their fundamentals, which help spread out the risk more than they help make any gains. However, that is not to say that the junk assets couldn’t hurt you.

Remember the sub-prime mortgage loans that caused the recession in 2008? Those bad loans were mixed in with a few good ones, so investors and insurers couldn’t tell the difference. You have to know the balance in the ETF between the performers and the junk before investing in it.

Jason Spatafora, the co-founder of marijuanastocks.com, says, “Most of these ETFs will have a certain amount allocated to several companies where the top five marijuana stocks are good, but then there is a huge drop off in quality in the other stocks. Everything else is more risky.” This sums up the nature of most ETFs. They are a mix of good and bad investments hoping that the good will outweigh the bad.

ETFs can be a great way to invest in cannabis without picking individual stocks. However, there are a few things you should consider before investing in one. Specifically, you should look at the index that the ETF is tracking, the tracking difference, rebalancing frequency, the nature of the fund’s management and the percentage of junk stocks. By taking these things into account, you will be able to decide which cannabis ETF is suitable for you.

Please contact us for more information on how to identify the right cannabis ETF for your portfolio.

 

ABOUT THE AUTHOR

Elizabeth Morris