The most popular marijuana ETF is more dangerous than you may realize

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Although it probably took a bit longer than cannabis enthusiasts and marijuana stock investors would have liked, the weed industry has been validated following the passage of the Cannabis Act in Canada and the subsequent legalization of adult-use sales on Oct. 17. No longer viewed as taboo, the pot industry is open for business.

According to a recently released report from Arcview Market Research and BDS Analytics, global cannabis sales are set to soar from $12.8 billion in 2018 to as much as $31.3 billion by 2022. Meanwhile, investment bank Cowen Group is being even more aggressive in calling for $75 billion in worldwide sales by 2030.

That's a lot of money, and it raises the question: "Where will it end up?"

The first-ever marijuana ETF has been a popular choice among investors

It's this uncertainty about a very new industry that's still trying to find its footing that's made the Horizons Marijuana Life Sciences ETF (NASDAQOTH:HMLSF) extremely popular. The very first cannabis exchange-traded fund (ETF) to come to market in 2017 has doubled since making its debut in Canada in early April 2017, and it's getting awfully close to once again hitting 1 billion Canadian dollars in assets under management following the incredible run higher in pot stocks since the year began.

Generally speaking, ETFs are designed to be investor-friendly. Sure, you'll pay a management fee -- 0.75% for the Horizons Marijuana Life Sciences ETF -- but you'll presumably have your risk spread out across a basket of companies. That way, if one or two marijuana stocks were to completely nosedive, it wouldn't wipe out your investment. Plus, it takes a lot of the time-consuming research off your plate, since you're paying someone else to buy and sell stocks out of the fund.

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As of Feb. 7, the Horizons Marijuana Life Sciences ETF owned 49 securities that are directly (i.e., growing, processing, or distributing cannabis) or indirectly (providing financing, packaging, software solutions, and so on) involved in the marijuana industry. That looks to offer, on the surface, plenty of diversification. But looks can sometimes be deceiving in the investment world.

A basket covered in dollar bills that contains three golden eggs.

The Horizons Marijuana Life Sciences ETF isn't very diverse

Despite holding more than four dozen different securities, the ETF of choice among marijuana investors is actually not as diverse as you might think. As of its latest holding update, the fund had 68.05% of its assets invested in just seven pot stocks:

  • Canopy Growth (NYSE:CGC): 12.37%
  • Aurora Cannabis (NYSE:ACB): 11.51%
  • Cronos Group (NASDAQ:CRON): 11.47%
  • GW Pharmaceuticals: 8.74%
  • Scotts Miracle-Gro: 8.13%
  • Aphria (NYSE:APHA): 8.10%
  • Tilray: 7.73%

Conversely, that means the remaining 31.95% of its capital is split up between 42 other holdings. 

On one hand, yes, you do have some serious potential market movers on this list. Canopy Growth, Aurora Cannabis, and Aphria have peak annual production potential of north of 500,000 kilograms, 700,000 kilograms, and 255,000 kilograms, respectively. That might represent 40% of what all Canadian growers generate in a given year.

This grouping is also rife with dealmaking ability. In December, tobacco giant Altria announced that it was taking a $1.8 billion equity stake in Cronos Group, with Modelo and Corona beer maker Constellation Brands closing a $4 billion investment into Canopy Growth in November. Then there's Tilray, which formed a global non-combustible product distribution deal with Novartis' generic subsidiary, Sandoz, and a cannabis-infused beverage joint venture with Anheuser-Busch InBev, in December.

But there's also plenty of concern with having so much of this marijuana ETF's assets tied up in these seven pot stocks.

A risk dial turned to its maximum setting.
 

Caveat emptor

Arguably one of the biggest issues is that, with the exception of Scotts Miracle-Gro, which generated 87% of its revenue in 2018 from its traditional lawn and garden business, the other six marijuana stocks aren't profitable on an operating basis. In fact, during the last round of earnings reports in November, Canopy Growth and Aurora Cannabis delivered operating losses of 215 million Canadian dollars (CA$215 million) and CA$112 million, respectively. Even giving these rapidly growing giants some leeway, these are not small figures that are easy for fundamentally focused investors to overlook.

In other instances, we also see a very big disconnect in valuation between existing production and current market cap. Many investors would argue that Aurora Cannabis' peak potential of around 700,000 kilograms a year makes it well deserving of a $7 billion-plus valuation, if not higher. But go ahead and try to explain Tilray's and Cronos Group's market caps of $7.4 billion and $3.5 billion, respectively, with only around 80,000 kilos and 120,000 kilos of peak production potential at the moment.

And yes, there are also dilution worries with a majority of these seven marijuana stocks. Aurora Cannabis, in its desire to expand its capacity, has made a number of acquisitions since the beginning of 2018, nearly all of which have been financed entirely by issuing common stock. In less than five years, Aurora's outstanding share count will have ballooned from 16 million to north of 1 billion.

There are even legal issues to contend with, as Aphria is currently battling short side firm Quintessential Capital Management and forensic analysis company Hindenburg Research. A report co-authored by this duo suggests that Aphria acquired three Latin American assets for an inflated price from SOL Global Investments. The report claims that these assets had been purchased by SOL Global for a fraction of their sale price to Aphria. Even with Aphria denying these claims and conducting an internal review, there's the potential for a loss of shareholder confidence with Aphria.

The Horizons Marijuana Life Sciences ETF may offer the feel of diversity, but it has far more risk built in than investors might realize.

 

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