The rising value of the international marijuana market means that more people than ever are interested in investing in cannabis stocks.
However, some investors are still put off by the sector's high level of volatility. In 2018 many companies saw their share price spike at the beginning of the year, only to find it tumbling lower during the subsequent months.
Although the industry has continued to gain legitimacy worldwide, cannabis stocks still carry a high degree of risk when compared to other agri-pharma investments.
While this is normal for any speculative industry, it's important to remember that diversification can be an effective shield against a sudden shift in the market.
First-time investors may even struggle to determine which type of cannabis stock to invest their money in. Cannabis growers, support specialists and derivative players each operate in a completely different area of the market, which can make it hard to build an adequately diverse portfolio without a significant amount of investment capital.
One solution for traders looking to diversify their investment is to buy into an Exchange-Traded Fund (ETF), which can offer wide exposure to some of the industry's biggest players.
Breaking Into a Budding Market
An ETF is a pooled investment vehicle which can allow thousands of investors access to a large basket of investments that are typically linked by some shared trait. There are thousands of ETFs that are currently active in the international marketplace, covering every financial sector on the planet.
Each ETF share grants its owner a proportional stake in the total assets belonging to the fund. The price of ETF shares is driven by the value of the assets held by the fund, with any rise or fall in the asset's value corresponding to a change in the stock's value.
Generally speaking, ETFs function by passively tracking various benchmarks—typically an index compiled by the fund's issuer or a third-party creator—and investing with the objective of matching the returns of the chosen benchmark.
This is similar to a mutual fund, although ETFs have the added advantage of being available for purchase or sale at any time during the trading day, giving flexibility-focused investors greater market maneuverability. This can allow investors to capitalise on a sudden business opportunity that may have by vanished by the time the market closes.
Instead of working directly with shareholders, the majority of ETFs make use of specialised market makers to facilitate trade. Market makers create new ETF shares by purchasing the assets or underlying stocks held by the fund and then transferring them directly to the company. The ETF will then subsequently issue shares which can be sold on by the market maker.
Under this structure market makers can also trade blocks of ETF shares to the company in exchange for corresponding investment securities, ensuring that the fund remains efficient while also allowing it to access certain tax benefits.
ETFs are often known as a "set-it-and-forget-it" investment, as most funds typically lack an active portfolio manager. Although some funds do have investment guidance, most are passively operated as managers who favour a more active strategy will generally choose a different investment vehicle due to the daily disclosure requirements of an ETF.
For tax purposes, most ETFs are structured as registered investment companies. This means that any taxable income generated is legally required to be passed back through their shareholders, as the ETF will seldom be required to pay any corporate taxes at the fund level. This is why ETFs make payments to investors as a distribution rather than a dividend. Most funds typically accumulate multiple dividends over brief periods of time, then distribute the collected total at regular quarterly or annual intervals.
So what's so special about an ETF?
The biggest benefit of investing in an ETF is the portfolio diversification they provide. Even owning a single share will give investors significant exposure to the entire cannabis market, ensuring that their overall investment remains healthy regardless of whether an individual pot stock fails.
Another added bonus of buying into a marijuana ETF is that they lack most of the negative tax attributes commonly associated with mutual funds. Typically speaking, when a mutual fund sells shares of its assets at a profit it then has to distribute the resultant capital gains tax liability to its' shareholders. Unfortunately, as these distributions typically take place towards the end of the year, they can wind up causing a significant increase in your tax bill, even if you automatically reinvest the money into additional shares in the fund.
Luckily, investors in an ETF are often able to avoid paying taxes related to capital gains as long as they hold on to their shares in the fund. This is because ETFs typically make substantially fewer trades in their investment portfolio compared to mutual funds, which results in a lower tax liability being passed on to shareholders each year.
ETFs also offer a cost-effective way for budget-conscious investors to buy into the market, as most funds don't charge the cripplingly high management fees normally associated with mutual funds. ETF investors are able to avoid these fees because the responsibilities of the fund's manager are typically limited to tracking the performance of its' benchmark index. This cuts out the cost of hiring investment specialists to pick certain stocks over others in an attempt to ensure the fund successfully outperforms the market.
The lesser fees associated with an ETF means that they often offer the lowest-cost option for investors looking to gain wider exposure to the international cannabis market.
ETFs are a great option for those who are looking to make a long position on their investment, as their long-term growth and comparatively low costs mean they can offer significant returns.
Buying into an ETF is also a good way to ensure you aren't left in the dust as the international cannabis market picks up speed. Although the industry is still evolving, investors should remain aware that reason so many cannabis stocks are high risk is because in the long run, many companies will eventually fall by the wayside, leaving the few that rise to the top to battle it out for market dominance.
Putting your money in an ETF won't eliminate the risks involved entirely—no investment option ever can—but as long as the cannabis industry burns brightly then it won't matter if a few companies eventually go up in smoke.