Marijuana legalization is creating big business opportunities. As of February 2024, 24 states, Washington, D.C. and three territories have legalized recreational marijuana use, while an additional 16 have some form of medical cannabis. Several companies have launched exchange-traded funds (ETFs) to capitalize on the new green businesses.
Cannabis ETFs provide investors with exposure to companies that deal directly and indirectly with the growth of marijuana plants, as well as software, technology, and other parts of the industry. The best-performing cannabis ETFs may provide investors with substantial returns.
But because of the complicated issues surrounding the legality of cannabis, there are still challenges these ETF issuers face. A major one is the issue of custody: Who will hold these ETFs' securities? Regular ETFs use custodians to handle their assets, but those involved with pot stocks and securities may have to go through broker-dealers.
What's the difference? Keep reading to find out more about these two entities as well as the implications of pot-related ETFs.
Key Takeaways
- Custodians are large financial institutions that hold their customers' securities.
- Broker-dealers can buy, sell, or hold securities for their clients.
- Although regular ETFs use custodians, cannabis ETFs may have to use broker-dealers to hold their assets because the drug is still illegal at the federal level in the U.S.
- Some pot ETFs are using bank custodians but have to provide additional details up front, including about potential securities in which they would invest.
Custodians vs. Broker-Dealers
Custodians are large financial institutions that hold securities on behalf of their customers. As such, they're responsible for safeguarding their clients' assets, whether they are in physical or electronic form. These entities may also provide other services such as tax support, account administration, transaction settlements, and interest payments.
By contrast, broker-dealers tend to range in size, from small independent operations to subsidiaries of large investment banks. These entities buy and sell different securities for their clients. They can hold stocks just like bank custodians do, and they are also free from federal banking laws.
Traditional ETFs use custodians for sending and receiving payments and holding the cash and securities held in the fund's portfolio. But questions of custody have become a key issue when it comes to marijuana ETFs, because many major banks are reluctant to hold funds invested in cannabis.
Although recreational cannabis is now legal in 24 states and medically available in many others, the specifics of legalization policies vary from state to state. If that weren't complicated enough, marijuana is still illegal at the federal level. That makes it difficult for a potential custodian bank to assess exactly what this role looks like when dealing with a group of marijuana companies.
Even if the cannabis companies are headquartered in places with full legalization, U.S. banks still assume responsibility when dealing with the Department of Justice. In short, a marijuana ETF's bank custodian could face legal trouble as a result of banking laws at the federal level because of its classification as a controlled substance.
If you're interested in investing in the marijuana industry, keep your capital, time horizon, investment goals, and risk tolerance in mind—the same way you would with any other industry.
What Does That Mean for Cannabis ETFs?
ETF issuers must consider custody when they invest in marijuana-related companies, because some banks may be unwilling to handle securities for an industry that is still illegal on a federal level. However, as the laws change, more banks are willing to accept the risks of banking the pot industry.
Take the example of U.S.-based ETFMG Alternative Harvest ETF (MJ), the first U.S. cannabis ETF with $241 million under management, as of February 2024. In 2018, U.S. Bank—a federally chartered bank and the custodian of the original fund—ended its relationship with MJ without explanation. The fund had to transfer its assets to broker-dealer Wedbush Securities for several years until it resumed its relationship with U.S. Bank.
Some cannabis ETFs avoid legal issues by investing in companies that are not directly involved in producing recreational cannabis, such as medical cannabis research, or financing the industry. These rules eliminate companies that cannot operate legally at the federal level.
You May Pay More
Though the issue of custodian versus broker-dealer may not seem directly relevant to a potential cannabis ETF investor, there are a few important things that investors should keep in mind. Watch out for the potential of added costs involved in participating in these funds. This may happen because of additional audits required by the Securities and Exchange Commission (SEC) depending on the status of who's holding the securities. The SEC requires custodians for investment vehicles such as ETFs to submit to annual audits of the assets contained in those funds if they are not already subject to annual audits. A privately traded broker-dealer would not normally be subjected to these audits, so that would increase the cost of auditing requirements significantly.
What Is the Biggest Cannabis ETF?
The largest cannabis ETF available to U.S. investors is the AdvisorShares Pure US Cannabis ETF (MSOS), with $961 million under management, according to VettaVi. As of February 2024, it has holdings in 24 companies.
Which Marijuana ETF Has the Highest Returns?
The Roundhill Cannabis ETF has the highest long-run returns as of February 2024, with one-year returns of 53%. The AdvisorShares Pure US Cannabis ETF has the second-highest returns, with 44% over a year.
What Is the Best Performing Cannabis ETF of 2024?
The AdvisorShares MSOS 2x Daily ETF(MSOX) had the top returns of 2024, gaining 69% since the start of the year as of February 2024. This fund uses leverage to provide twice the daily returns of the MSOS. Note that, as a leveraged ETF, MSOX may incur high inter-day volatility and expenses that can eat into any potential gains.
The Bottom Line
Things are certainly changing for the marijuana industry at the state level. But because the drug is still illegal at the federal level, investors need to take a step back and rein in their excitement. Be sure to watch out for additional fees that cover things like surprise audits. And just like any other investment, it's important to do your research before you put any money down.
