Photographer: Benjamin Rasmussen/The New York Times via Redux

Dude, Where's My Pot ETF?

It seems inevitable—but there's this little liquidity problem

Pot has been generating lots of buzz. 

Twenty-three states and the District of Columbia have legalized marijuana, either for medicinal or personal use, while an additional 13 have planned votes by 2016. If the trend toward legalization continues, there's big profit potential, considering $2.5 billion in legal sales last year—and the estimated $60 billion in illegal sales. ArcView Market Research estimates that the national cannabis market will reach $10.8 billion in sales (retail and wholesale) by 2019.

While there are exchange-traded funds for rare earth metals and for stocks headquartered in Nashville there are no ETFs that track pot stocks.

An argument against a pot ETF is that the stocks are tiny and volatile. That may actually be the best reason for such an ETF, since volatility can be lessened through diversification. 

An example of how that can work is the PureFunds CyberSecurity ETF (HACK), which tracks another fledgling industry. It's also made up of largely super-jumpy stocks that no one has heard of and that have a far higher-than-average risk of blowing up. Those stocks have an average volatility four times greater than that of the Standard  & Poor's 500-stock index. HACK's volatility level is "only" twice that of the S&P 500. Diversification basically cuts the volatility in half. That can make for a much more palatable investment into a upstart industry.

Still, while there are 55 public companies whose business is based largely or completely on marijuana, they have only a combined market cap of $4 billion—and most are miniscule, according to Bloomberg Intelligence. Even the iShares Microcap ETF (IWC), which tracks the smallest of the small stocks, has a portfolio of stocks whose total market cap equals $58 billion. In short, there just isn’t enough liquidity or size yet for a robust, pure-play pot ETF.

That doesn’t mean the idea should be abandoned. Here are two possible ways a pot ETF could be created right now1

Pot stocks—and friends 

One idea is to build an ETF that includes pure pot stocks, as well as “related” companies. That would help give the ETF more liquidity. For example, Scott’s Miracle-Gro, maker of lawn care products, recently bought a hydroponics supplier and has said it plans further acquisitions to participate in the growth of legal pot. Scott's is a $3.7 billion company that trades about $10 million worth of shares a day. Not a direct hit by any means, but related.

The ETF could also include some downstream beneficiaries of pot consumption such as Yum! Brands (Taco Bell, Pizza Hut, KFC, and so forth), Netflix, Urban Outfitters, and Game Stop.2 Before you laugh, keep in mind that this is how other, very popular ETFs are constructed, such as the $1.7 billion SPDR Homebuilders ETF (XHB). Only 33 percent of XHB is invested in homebuilder stocks. The rest are stocks in related industries, including home furnishing, retail, building materials, and electronics. 

Big tobacco is expected to jump into the pot game at some point. Over time, the ETF would shed the indirectly related stocks and take in more directly related stocks, increasing the fund’s overall THC level. 

Pot stocks, in a wrapper

Pot may be a perfect example of when an exchange-traded note (ETN) makes more sense than an ETF. ETNs don’t have to hold any of the stocks. The notes are unsecured debt obligations that are basically, promises to pay the returns of an index. So it doesn’t matter if the stocks are illiquid or not. What matters most is the creditworthiness of the ETN issuer. 

ETNs were first introduced 10 years ago for this very purpose—to get into places that were particularly tough for ETFs to track. For example, the iPath India ETN (INP) was launched in 2006 to get around the strict foreign ownership restrictions that made an ETF impossible. It accumulated more than $1 billion within two years.

An ETN issuer could do the same thing, using a self-made pot index or something like the MJIC Marijuana Global Composite Index. The downside to ETNs is there is always risk that the issuer will default, just as with a bond. For investors "jonesing" hard enough for a pot ETF, this may not matter. 

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  1. 1 The ticker it can't have right now, or presumably ever: POT. That's taken by Potash Corp. of Saskatchewan. 
  2. 2 These ideas were generated by a highly unscientific survey of people who recently graduated from college.