A cloud looms over the newly traded marijuana ETFs, and it's something—or someone—that most investors don't know anything about.
Custodians are the independent third parties, usually banks, whose sole task is to hold securities for an exchange-traded fund. Though they often go unseen and unnoticed, custodians play a critical role in the launch and operation of any fund. Without custodians, there can be no ETFs.
But when it comes to marijuana ETFs, custodians remain wary, at best.
Until recently, most big banks refused to shoulder the reputational and possible legal risk of having their brands associated with a cannabis fund. Nevermind Attorney General Jeff Sessions' anti-marijuana crusade. Holding stocks involved with a drug still outlawed by the U.S government could potentially run a bank afoul of federal banking laws, maybe even cost them their FDIC insurance or banking license. It was perceived as simply too wide a river to cross.
Nothing. Despite MJX's overnight success, custodian fears haven't been laid to rest—not even close, according to sources. The possibility a custodian might yank support of MJX, or any marijuana ETF, is being discussed throughout the ETF industry.
This article results from conversations with more than a dozen knowledgeable industry sources, many of whom spoke to ETF.com only on condition of anonymity, given the sensitivity of the issue.
Right Time For A Pot ETF
After decades of demonization, the tide is finally turning for marijuana. Legal pot sales in North America, which are projected to hit $10 billion for 2017, will likely quadruple over the next decade. Medical marijuana has already been legalized in 29 states, while recreational marijuana is now legal in eight, including California as of the start of this year.
Yet marijuana remains illegal at the federal level. The U.S. government still classifies cannabis as a Schedule I substance under the 1970 Controlled Substance Act (CSA), which places it alongside heroin, MMDA and ecstasy as drugs with a high potential for abuse and no approved medical usage. "There are some big dominoes falling," said Eric Balchunas, senior ETF analyst for Bloomberg. "A major wave could sweep the nation soon, because there's a lot of money here."
Already, the world's first pot fund, the Canadian Horizons Marijuana Life Sciences Index ETF (HMMJ), has gathered $713 million in assets in just over nine months of trading, though MJX’s rapid asset gathering could soon eclipse that figure.
What's remarkable about HMMJ, says Balchunas, is how sticky its assets are. Shortly after the ETF launched, HMMJ's price plummeted over several months. But the $150 million in assets the fund had already gathered stayed put:
HMMJ Assets Since Inception vs. Price Performance
Source: Eric Balchunas, Bloomberg. Data as of Dec. 21, 2017. Reprinted with permission.
For a larger view, please click on the image above.
"That's really rare," said Balchunas. "Usually flows are correlated to performance; most products won't get assets if they don't perform. That indicates real pent-up demand."
Federal Vs. State Law
So if there was pent-up demand from investors, why did it take so long to bring marijuana ETFs to market, and why have so many filings languished without approval?
It all comes back to custodians.
Custodians tend to be large, well-established banks, such as BMO, BNY Mellon and U.S. Bank. Federally licensed and chartered, they're staid, trusted institutions with the resources on hand to buy and sell large quantities of securities as needed.
As such, these banks are reticent to run afoul of federal laws, which prohibit the production and sale of marijuana, and which classify any pot-related financial transaction as money laundering.
Flexible System?
Obama-era guidelines, however, introduced some flexibility into the system, granting states the ability to legalize the growing and selling of pot within their own borders. It also permitted state and community banks and credit unions to do business with marijuana companies, and discouraged federal prosecution of any cannabis company that was following state law.
The Drug Enforcement Agency (DEA) also introduced registration procedures to help ensure that marijuana companies weren't using their money to fund any illegal activities.
On Thursday, however, U.S. Attorney General Jeff Sessions announced plans to rescind these 2014 guidelines, stating that the federal complete marijuana ban would once more take priority over individual state law.
This has introduced uncertainty into the future of the legal marijuana industry, though it is too early to tell exactly what impact it will have. Even so, MJX lost 8% in intraday trading on the news, though it quickly recovered some of those losses.
Custodians Remain Wary
Until recently, few custodian banks showed any interest in wading into this potential legal minefield. One high-level ETF executive, who asked not to be named, had approached several custodians about launching a marijuana ETF, including SEI, BNY Mellon, BMO and U.S. Bank.
In each instance, initial interest over the fund was replaced weeks later with a hard no from senior compliance and risk officers or legal departments. Sometimes fund servicers were even reprimanded for bringing the proposal to their higher-ups.
"Every single time a fund-servicing person expressed excitement, every single time we eventually were told no, that it was against company policy," said the executive.
It's not that the underlying marijuana stocks themselves were verboten, since many custodians already hold these for other contexts. For example, Canopy Growth Corp., a Canadian medical marijuana producer, is both the fourth-largest holding in MJX and the largest holding in the nonmarijuana-related IndexIQ Canada Small Cap ETF (CNDA).
Potential Jeopardy
Instead, the problem is that custodians would be holding these stocks specifically for a marijuana ETF. When a federally chartered, licensed and insured bank declares that the primary reason it is holding marijuana companies is to provide exposure to a federally illegal substance, the bank could be jeopardizing its entire business.
"Any bank covered by FDIC runs the risk of taking funds deemed tainted by the U.S. government under the CSA and [being] denied their FDIC insurance," said specialized ETF consultant Bob Tull, who has helped launch nearly 400 ETFs. "They might also lose their banking license. There's no client big enough to run that risk."
Investing in Canada-domiciled or other foreign pot stocks offers little solution either, says Tull. Though the companies fall outside the U.S. Justice Department's jurisdiction, the ETF investing in them does not. "It's a complex legal issue that's not going to be easily solved," he said.
ACT: When Vice Is Virtue
The two cannabis ETFs now trading in the U.S. have approached the custodian issue in very different ways.
In the case of ACT, Dan Ahrens, managing director and chief operating officer of AdvisorShares, acknowledges that the problem was so difficult that he demurred for years on launching a pot-related ETF, even though he himself had launched a well-performing “vice” mutual fund many years prior.
"Many people contacted our firm over the years about creating a marijuana ETF, and we told them no," said Ahrens. "It's just not going to work in the U.S., because of federal regulation, and because there are so few large, liquid and exchange-listed companies to invest in. I still believe that."
For ACT, the solution was to forgo pure-play exposure in favor of a broader "vice"-themed portfolio. ACT holds only a minority stake (20%) in cannabis companies, all of which are federally legal U.S. pharmaceutical or biotech firms registered with the DEA.
ACT's marijuana exposure is blended with larger, more liquid stocks, including companies tangentially related to the industry, such as fertilizer makers; big R&D firms whose revenues are only minimally driven by cannabis activities; and forward-looking marijuana plays, like alcohol or tobacco companies, many of which have announced significant investments in the pot industry.
"It took a great deal of work and cooperation between our custodian bank, the listing exchange and even the SEC" to bring ACT to life, said Ahrens. "We limited ourselves to only those companies that are federally legal. I can't stress that enough. 'Federally legal' is how we got everyone to agree."
Curious Case Of MJX
ETFMG's MJX, however, took a different route to launch.
Instead of the usual filing-to-launch process, ETFMG retrofitted one of its existing ETFs with a new index: Prior to Dec. 26, MJX tracked Latin America real estate and carried the ticker "LARE” (see: "When An ETF Changes Its Exposure").
In doing so, ETFMG circumvented the need to find a new custodian or get the SEC's green-light for a de novo ETF. Despite the dramatic difference in LARE’s and MJX's indexes, the ETF had already been approved once and would not need to be reapproved. ETFMG didn't even need to get input from its custodian, U.S. Bank, before making the change.
This likely wasn't ETFMG's preferred method of launch. ETFMG had filed for another marijuana-themed ETF back in February 2017, but had had little success in securing the SEC's approval, according to multiple sources in the position to know.
By switching the index of an existing fund instead, the wait time for launch was condensed from some indefinite number of months or years to just a 60-day wait period (that is, after ETFMG gave investors notice of the change, which they did in late October). That gave ETFMG a valuable early-mover advantage, though ACT was in fact first to market.
ETFMG did not respond to repeated requests for comment.
Sudden Closure Risk Remains
According to multiple sources, discussions continue internally at U.S. Bank as to whether to continue serving as custodian for MJX. The relationship is by no means guaranteed.
In fact, prior to MJX's index switch, U.S. Bank had demonstrated little appetite for a marijuana ETF, turning down multiple proposals similar to MJX from other issuers. Another complicating factor is the likelihood of increased scrutiny from the Justice Department on the marijuana industry as a whole.
"I've never heard of a custodian rejecting an ETF," said Elisabeth Kashner, director of ETF research for FactSet. "As far as I know, it's never happened."
If U.S. Bank decides to terminate its agreement, that could leave MJX without a custodian—and the ETF without any clear future. The fund might have to find another advisor on short notice, re-domicile overseas or, in a worst-case scenario, close.
But nobody knows where the chips will fall.
"I still hold out 5% skepticism that something might still happen, but for now, it appears the name-change from LARE to MJX worked," said Balchunas. "If its custodian is fine with it, if the SEC is fine with it, then I don't see why one of the other marijuana ETF filings waiting wouldn't get approved as well."
