Leveraged Pot ETFs: Just What Investors Don't Need

I won’t name names but an ETF provider is launching a fund that allows an investor to receive two times the returns on the Cannabis sector. While the ‘short’ ETF has some risks that investors should think about if considering, it is not nearly as irresponsible, in my opinion, as a double leveraged Pot ETF. Let us walk through some of the reasons why markets do not need a leveraged Pot ETF.

This is a very volatile space to begin with

If we use the more prominent Cannabis ETF in Canada (HMMJ) as a proxy for the sector, we can get an idea of what one might expect from this space. For better or worse, the historical data here is limited because both the sector and any ETFs are so new. However, according to Refinitiv, since HMMJ has traded over the last two years, it has seen daily drawdowns to the degree as outlined below:

Between

Count

0%

-5%

87

-5%

-10%

6

-10%

-15%

2

-15%

-20%

0

-20%

-30%

0

-30%

-40%

0

-40%

-50%

0

-50%

-100%

0

To clarify, on a daily basis, HMMJ which is a basket of stocks in the pot sector, has seen a one-day drawdown between 10% and 15% two times already. One day. It has seen six cases of a drawdown between 5% and 10%. Now let’s put a double leveraged lens over this. If an investor was holding a double leveraged version of this fund, there would have been two instances where they could have seen a 20% to 30% drawdown the day after owning this fund. Sure, this risk exists with single stocks as well but this is a diversified fund and not a single stock. The default assumption is that the ETF is less volatile than the underlying holdings.

Let’s look at monthly drawdowns next:

Between

Count

0%

-5%

4

-5%

-10%

6

-10%

-15%

1

-15%

-20%

1

-20%

-30%

1

-30%

-40%

0

-40%

-50%

0

-50%

-100%

0

The monthly drawdowns have also been severe in what is essentially a two-year period. Again, don’t forget to apply the double leverage lens where there was an instance over a month where an investor could have lost 40% to 60% of their value.

But what about the ‘good times’ is a rebuttal I can hear. Yes, there certainly were good times and continue to be good times for cannabis investors. That is kind of the point though. If the space is going to do so well, you don’t really need to leverage up the investment. Also, psychologically, it is way less stressful to hold on through a 50% gain than it is a 50% loss. So, in most cases, an investor is likely to sell at a low when they see a large bout of downside volatility. It is easier to say you can hold on to a stock or ETF during a one day 20% decline than to actually do it in real time. 

Valuation risk is high

This piece is not here to make any comment on valuations or the future direction of the cannabis sector. It might do well or it might not. The one thing an investor can be more confident in though, is that it will be volatile. If past trading history is not enough, then looking at the valuation might be a hint at how much volatility one can expect. The top four holdings in HMMJ, which make up roughly 40% of this fund, trade at a price to sales multiple of no less than 15 times forward sales. That’s 15 times top-line revenue without even considering profits and margins. Again, we are not here to beat up on valuations today but with valuations at that level, one should expect above average volatility.

If we can expect so much volatility, then why do we need to add torque to what is already a highly volatile investment? Well, we don’t. This is not even like adding fuel to a fire, but more like throwing the whole fuel tank into the fire.

The sector is still a new one

A lot of uncertainty remains in the space and there are a lot of unknowns because it is so new. So, adding leverage to so much uncertainty is again very risky. It is one thing to already own the sector but I think you would be hard pressed to talk to any investment professional that today or even in hindsight would say you should take a loan out and invest in pot stocks. This is essentially what this fund allows you to do.

It plays with investor emotions and dopamine 

An investor will look at the historical chart of something like HMMJ, see it is up 135% since it launched and multiply that number by two and think it looks like an interesting proposition while ignoring all of the valleys this space saw as well. It simply plays with the fact that investors tend to see a return number and then draw a straight line without considering how a holding got there in the first place.

Deep down, ETF providers know that investors do not need this, yet, they will use risk disclosures as an excuse

If this fund blows up, the ETF provider will pull out their 50-page prospectus and say ‘look, we warned you. It is you the retail investors fault.’ Just like in 2008, ‘we offered you all those mortgages but no one forced you to take them.’ We see this so often and is one of the more frustrating aspects of the industry. Yes, there is some degree of responsibility an investor needs to take for their decisions and in fairness, it should be easy to see why this fund is very high risk. However, offering what is arguably a high-risk product such as a regular Pot ETF or an Oil ETF is one thing. Amplifying the returns with leverage and packaging it like it is just another ETF is a total other animal.

It would be interesting to be in the boardroom where these conversations happened. Did anyone dissent, or simply raise the issue of whether anyone even needs a leveraged pot ETF? Do the ETF providers need to take on the potential brand and reputational risk that these types of funds might bring on? Not only do investors not need a fund like this but we might argue the ETF providers don’t really need it either. 

Back to the risk disclosures, investors, especially retail investors, on average, do not read an ETF prospectus. Shocking as it may be, it is probably the truth for right or wrong. The ETF providers more than likely know this better than anyone else. The buyer beware, while true to some degree is also a cop-out in cases like this. The product provider, in our view, should simply know better and have the foresight to see how a fund like this can be dangerous for the intended market.

Also, don’t forget, the providers of funds like this get their fees regardless of performance. They do not have a vested interest in whether you make money on this fund. It’s nice that there is a ‘demand’ but just because someone wants something, does not mean they should get it. They simply see a demand and are trying to supply the demand with a dangerous product. Much like a drug dealer.

So, there are all of the reasons it is my opinion that a leveraged Pot ETF is simply not needed. What irks me the most about this kind of thing is that there are so many opportunities for interesting and creative and useful ETFs in Canada. Instead we get two pot ETFs and the plethora of dividend funds. Here is some free consulting on products ETF providers could roll out where there are not any great offerings or any at all. You don’t even need to pay us if you run off with one of these ideas:

Small-Cap – There is only one or two small to mid cap ETFs in Canada (XMD and XCS). The space is largely underserved and adding some sort of quality or dividend parameters could go a long way to making an interesting product.

TSX ex-commodities – The TSX is dominated by materials and energy. Some sort of product that allows an investor to gain exposure to Canada without holding volatile commodities could see demand. BONUS: There is likely a socially responsible (SRI) marketing angle one could take here.

TSX ex-financials – Similar to Commodities in that the TSX is dominated by what is large, slow growth, oligopolistic financials. Allowing investors to get exposure to the TSX without the financials can help balance out sectors and even support some TSX names that get less attention. 

Equal weight – We have done some research that has shown that a simple equal weight strategy on the TSX leads to outperformance over the long-term.

TSX dual class – We have done some research that shows dual class shares in Canada can outperform the TSX.

TSX Venture Quality – Best we are aware, there is no ETF for the TSX Venture exchange. Sure, there are a lot of low-quality companies here but adding a few extra rules such as ‘X years of profit’ or ‘low debt’ can probably go a long way in filtering out the junk.

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