Medical cannabis ETFs on cusp of mainstream breakthrough

Jun 29th, 2020 | By | Category: Equities

Overlooked by many and misunderstood by others, ETFs providing exposure to the medical cannabis industry represent an investment proposition that appears on the cusp of a mainstream breakthrough as fresh medical evidence of the pharmacological and therapeutic benefits of cannabis combines with changing attitudes and pro-legalization momentum worldwide.

Purpose medical marijuana ETFs

Green shoots of opportunity

This is the judgement of Greg Taylor and Nawan Butt, Chief Investment Officer and Portfolio Manager, respectively, at Canadian investment house Purpose Investments as explored in an ETF Strategy webcast sponsored by HANetf (see ‘Medical Cannabis ETFs: An Evaluation of the Investment Proposition’).

Purpose Investments, which is a leading provider of ETFs in Canada, oversees more than C$8 billion in assets under management and is a pioneer in the medical cannabis investment space.

In January 2018, it launched the first dedicated actively managed medical cannabis fund in Canada, the Purpose Marijuana Opportunities Fund (MJJ CN), while earlier this year it set a new milestone by becoming the first company to introduce a medical cannabis ETF in Europe.

Created in partnership with London-based white-label platform HANetf, The Medical Cannabis and Wellness UCITS ETF (CBDX LN) is passively managed and listed on the London Stock Exchange, Xetra, and SIX Swiss Exchange. The fund comes with an expense ratio of 0.80%.

According to Taylor, the ETF offers investors a liquid and transparent vehicle to tap into one of the world’s largest consumer growth stories. He notes that the use of marijuana for medicinal purposes dates back thousands of years yet has largely been hidden within black and grey markets.

This has changed dramatically in recent years, however, due to sweeping pro-legalization reforms from governments looking to fix their balance sheets by boosting tax revenues.

In 2001, Canada became the first country to legalize marijuana for medical use. Since then, a further 30 countries have also fully rescinded their restrictions on medical cannabis including Argentina, Australia, Chile, Croatia, Cyprus, Czech Republic, Denmark, Finland, Germany, Greece, Ireland, Israel, Jamaica, Lithuania, Luxembourg, Malta, Netherlands, New Zealand, Norway, Peru, Poland, Portugal, San Marino, Sri Lanka, Switzerland, Thailand, UK, Uruguay, Vanuatu, and Zimbabwe.

Another 12 countries (Austria, Belgium, Brazil, Estonia, France, South Korea, Philippines, Romania, Slovenia, Spain, Turkey, and the US) have also adopted legalization with some restrictions.

Due to this rapid change in attitudes, the global medical cannabis market is expected to grow from $11.7 billion in 2018 to $148bn by 2026, representing a compound annual growth rate of 26.4%.

This seismic shift is further facilitated by growing research into the effectiveness of marijuana as a treatment for a wide range of ailments with the World Health Organization recommending the ‘rescheduling’ of both of marijuana’s most well-known chemical compounds, THC and CBD.

To illustrate the plant’s potential, Butt explains that endocannabinoid receptors, which are found throughout the human body, allow for the communication and coordination between different cell types. The cannabinoid system’s main function is to promote homeostasis, the maintenance of a stable internal environment dispute external fluctuations. When cells become injured, cannabinoids decrease the release of activators, helping to stabilize nerve cells, reduce inflammation, and limit pain.

There are over 60 cannabinoids present in marijuana. The most researched, along with their effects and applications, are outlined below.

Source: Purpose Investments.

According to Butt, the commercialization of cannabis presents opportunities across four distinct categories: pharmaceutical cannabis, medical marijuana, CBD wellness, and recreational cannabis.

Pharmaceutical cannabis provides targeted treatment for specific medical conditions, and the segment is characterized by patented drugs, strict regulation, and high barriers to entry.

Medical marijuana combines several cannabinoids in an ‘entourage effect’ that helps alleviate symptoms associated with a wide range of diseases. The segment is highly controlled but less regulated compared to pharmaceutical cannabis.

CBD wellness focuses on CBD-based treatments to promote general health and vitality. CBD is non-psychoactive and is thus widely legal and available, and the segment has few regulations.

Finally, recreational cannabis uses the psychoactive compound THC to provide adults with the ‘high’ associated with marijuana.

According to Butt, the first three categories, broadly defined as medical cannabis, have the highest potential for market growth. Using estimates for people globally that suffer from certain medical conditions for which cannabis is now being used as an effective therapy, Butt points out that if just 10% turned to cannabis-derived products, this would create a market of over 100 million patients.

Big pharmaceutical companies have clearly sensed an opportunity and ramped up their pursuit of cannabinoid clinical trials in recent years with industry titans GW Pharmaceuticals and Sanofi leading the pack.

Source: Purpose Investments.

Source: Purpose Investments.

According to Butt, retail sales of medical cannabis products in the US have grown from $3.7bn in 2017 to $5.5bn last year, representing a CAGR of 21.9%. While many firms have established profitable businesses with consistent operating profits, the sector is also characterized by high research and development investment, a high proportion of fast-growing new entrants, and increasing consolidation activity.

In contrast to these high-growth markers, the recreational cannabis segment exhibits a very different risk and return profile.

Despite the hype and attention that it attracts, cannabis for recreational use is currently only legal on a federal level in just two countries – Canada and Uruguay – while Butt notes that perceptions around recreational cannabis remain divided.

Certain investors have also expressed significant reservations about investing in the recreational cannabis sector. In particular, UK-based investors are concerned with violating the 2002 Proceeds of Crime Act which permits the confiscation of proceeds from investments in businesses that are illegal under UK law even if the business is legal in the jurisdiction within which it operates.

For these reasons, Purpose Investments has constructed an investment approach that excludes firms catering to the recreational market and instead focuses solely on the high-growth potential within the medical cannabis genre.

The Medical Cannabis and Wellness UCITS ETF is linked to the Medical Cannabis and Wellness Equity Index which was created by Purpose and is independently calculated by Solactive.

The index consists of companies listed on major stock exchanges, such as the NYSE, Nasdaq, and TSX, which have a minimum market capitalization of $50 million. The relatively low market capitalization threshold allows the index to capture small, rapidly growing companies soon after their initial IPO, helping to boost the strategy’s growth profile.

Constituents go through an in-depth due diligence process to ensure firms are only conducting legal business activities in the medical cannabis, hemp, and CBD industry.

The index covers nine sub-sectors: producers and suppliers of medical cannabis; CBD-focused biotech companies; hydroponics and equipment suppliers; producers of medical cannabis consumer products; companies leasing property to medical cannabis growers; software solutions for medical cannabis producers; companies with an investment focus on medical cannabis; hemp and CBD consumer goods suppliers; and service providers, including equipment, manufacturing, and processing.

Constituents are weighted by market capitalization subject to a single-stock cap of 10%, and the index is rebalanced on a quarterly basis.

According to Taylor, this carefully constructed methodology aims to make the ETF appealing to a wide range of investors. He noted that initial investment in the Canadian cannabis sector was driven by family offices, hedge funds, and high-net-worth investors but soon turned mainstream with the adoption by mutual and pension funds. He sees a similar path playing out in Europe.

When asked about the fund’s performance this year, Butt responded that the strategy has held up well in the current environment. He did note that the ETF experienced a drawdown of around 40% during the Covid-19 market turmoil, compared to a 34% loss for the S&P 500, although this was broadly reflected in the stronger sell-off of high-growth assets.

Notably, however, the fund has exhibited an aggressive rebound with the underlying index just turning positive for the year. In contrast, the S&P 500 is still down around 6%.

According to Butt, this quick comeback illustrates that the market understands that the medical cannabis investment theme is underpinned by robust fundamentals including strong revenue growth for many years to come.

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