3 Reasons You Should Stay Away From Marijuana ETFs

Keith Speights, The Motley Fool

Updated Sun, Oct 7, 2018, 7:02 AM

I'm especially leery of the two marijuana ETFs on the market right now -- Horizons Marijuana Life Sciences ETF (NASDAQOTH: HMLSF) and ETFMG Alternative Harvest ETF (NYSEMKT: MJ). My view is that investors wanting to profit from growth in the cannabis industry are better off staying away from these ETFs. Here are three reasons why.

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1. They come with high expenses.

The fees associated with ETFs are typically a lot lower than those of mutual funds. However, the two marijuana ETFs have expense ratios that are higher than most ETFs. Horizons Marijuana Life Sciences ETF's expense ratio is 0.94%, while the expense ratio of ETFMG Alternative Harvest ETF is 0.79%. By comparison, several of the most popular index ETFs have expense ratios of less than 0.10%.

Just 10 stocks in the Horizons ETF account for roughly three-quarters of the ETF's total net assets. The ETFMG ETF isn't much better: The fund's top 10 stocks comprise nearly 65% of its total net assets.

Let's say you invested $2,000 in each of the top 10 stocks held by the Horizons Marijuana ETF and held them for one year. Using a discount broker, your commissions would total no more than $50 -- less 0.25% of the total $20,000 investment. That's a lot less expensive than the expenses associated with buying the ETF. And you get nearly as much diversification and exposure to the cannabis industry as the ETF provides.

2. They're heavily weighted with stocks with sky-high valuations.

The reason only a handful of stocks account for a large portion of these exchange-traded funds' net assets is that they're both heavily weighted with stocks with large market caps. The Horizons Marijuana ETF's top three holdings are Aurora Cannabis, Canopy Growth, and Tilray (NASDAQ: TLRY). ETFMG's top three holdings are Aurora, Tilray, and Cronos Group.

Tilray has become the poster child for what an overvalued stock looks like. Its market cap has skyrocketed to close to $14 billion despite having a lower annual production capacity than several of its peers with lower valuations. However, Tilray isn't the only top marijuana stock held by the ETFs that is arguably way overpriced.

I think that the growth prospects of the major Canadian marijuana growers over the next several years don't justify many of the market caps of these stocks. If the bubble pops, investors thinking that buying marijuana ETFs will provide diversification and reduce volatility will have a rude awakening.

3. They largely ignore the most important market.

Only two of the top 10 stocks in either of these marijuana ETFs have exposure to the U.S. market. For the Horizons ETF, the two stocks are GW Pharmaceuticals and Scotts Miracle-Gro (NYSE: SMG). For ETFMG, the stocks with U.S. exposure are GW and Corbus Pharmaceuticals.

But investors looking to make money from growth in the cannabis industry should realize that the U.S. currently generates 85% of total marijuana sales. That level will drop in the coming years, but the U.S. marijuana market will still be three times larger than the rest of the world combined in 2022.

The only stock in the top 10 holdings of either of these ETFs that is in position to benefit from the U.S. marijuana market is Scotts Miracle-Gro. GW Pharmaceuticals and Corbus are biotechs, so any revenue they might generate from approved drugs is separate from the marijuana market projections.

In my view, this is probably the most important criticism of both Horizons Marijuana Life Sciences ETF and ETFMG Alternative Harvest ETF. Canada claims an important marijuana market. So does Germany. But the U.S. market is and will be much larger. The marijuana ETFs, to a significant extent, ignore the most important marijuana market in the world.

The better alternative

Investors are better off buying individual stocks than putting their money into either of the top marijuana ETFs, in my opinion. Your expenses should be lower (depending on how much you invest, of course). You can buy stocks that don't have unjustifiable valuations. And you can include stocks that are poised to benefit from growth of the U.S. cannabis industry.

I'm a big fan of ETFs and have sizable positions in several. However, all ETFs aren't created equal. I don't think that the current marijuana ETFs deliver the value that investors might expect.

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Keith Speights has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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