Cannabis is known to have calming effects on some of its users. The same can’t be said for cannabis stocks. Investors have had to deal with high volatility in the newly emergent and rapidly growing sector of the stock market, and recently, some of that volatility appears to be linked to mega trades from a $1 billion exchange-traded fund (ETF), the ETFMG Alternative Harvest ETF (MJ), according to Bloomberg.

What It Means for Investors

During the final hour of trading last Friday, shares of medical marijuana producer CannTrust Holdings Inc. (TRST.TO) spiked about 40% while shares of shares of Auxly Cannabis Group Inc., Vivo Cannabis Inc., Supreme Cannabis Co. (FIRE.TO) and Canopy Rivers Inc. all fell by at least 13%. Coincidentally, the Alternative Harvest ETF, which sometimes goes by its ticker, MJ, had recently purchased 5.5 million shares of CannTrust and significantly reduced its holdings of the other four. Maybe it’s not a coincidence after all.

All those big trades were motivated by MJ’s need to rebalance after the weightings on its holdings had diverged from those on its underlying benchmark, the Prime Alternative Harvest Index. While the fund’s prospectus indicates that rebalancing occurs every quarter in order to reflect the changes in the index, flexibility to reposition in advance is allowed in order to minimize the impact on market prices, according to Bloomberg.

Such flexibility is important in order to keep pace with the sector’s volatility, said Eric Balchunas, one of Bloomberg Intelligence’s ETF analysts. “In the case of marijuana, it’s like taming a wild horse,” he said. “If it wasn’t able to make small adjustments on the fly because its underlying holdings are changing to quickly, it’s possible that is a worse evil than situations like this.”

The fund’s large rebalancing is a reminder of just how volatile cannabis stocks can be. CannTrust, for example, saw the value of its stock halve in early July following regulatory breaches. Since a stock’s portfolio weighting depends on the total value of shares held relative to the value of the overall portfolio, the halving of CannTrust’s stock induced a decline in its weighting to 2% of MJ’s holdings. Meanwhile, the stock’s weighting in the benchmark index is 4%; hence, the big purchase.

Another sign of the volatile nature of cannabis stocks compared to the rest of the market came in May, when shares of cannabis companies plunged by a third while the Nasdaq Composite Index dipped by just 5%. The big plunge was unmerited, according to GMP Securities’ Rob Fagan, who noted that American cannabis sales have been steadily improving. The selloff presents “a compelling opportunity for investors,” he wrote in early June, per Barron’s.

The state of Illinois, for example, recently legalized recreational pot and since December, sales of medical marijuana have doubled. The first five months of recreational sales in Massachusetts rose to a $400 million annualized run-rate compared to just $120 million in December. In Florida, where only medical marijuana is legalized, sales have grown at a 45% annual rate, and in Maryland, medical sales are up 55% on an annual basis. 

Amidst that kind of growth, May’s selloff is a bit surprising. But it’s likely that with so much uncertainty still over legalization and being a relatively new industry, much of the sentiment driving cannabis stocks has more to do with speculation than with the fundamentals of the underlying companies. The volatility will likely continue until markets figure out how to properly price the risks specific to the industry.

Looking Ahead

Given the speculative nature driving pot stocks, investors should take note that even within the sector, some funds are more speculative than others. The MJ ETF, despite its volatility, is fairly broad and encompassing in its holdings, whereas the AdvisorShares Pure Cannabis Fund (YOLO) has a greater focus on microcaps, tiny companies whose future profitability is still in question. Knowing this difference is at least half the battle in avoiding the sector’s large swings. Of course, while avoiding the lows is important, nobody wants to miss out on the sector’s highs.