People's attitudes about pot are changing. In fact, more people believe it should be legal—both recreationally and for medical purposes. Despite being classified as a controlled substance at the federal level, more states are taking the opposite route by legalizing marijuana. This not only has pot enthusiasts excited, but it also means big moves in the investment world.

Several companies have launched their own exchange-traded funds (ETFs) in an effort to capitalize on the moves sweeping the nation, giving investors exposure to companies that deal directly with the growth of marijuana plants, as well as software, technology, and other parts of the industry. But because of the issues surrounding the legality of cannabis, there are still challenges these ETF issuers face—notably, the issue of custody. Who will hold these ETFs' securities? Regular ETFs use custodians to handle their assets, but those involved with pot stocks and securities may have to go through broker-dealers. But what's the difference? Keep reading to find out more about these two entities as well as the implications of pot-related ETFs.

Key Takeaways

  • Custodians are generally large financial institutions that hold their customers' securities.
  • Broker-dealers range in size and can buy, sell, or hold securities for their clients.
  • Although regular ETFs use custodians, cannabis ETFs generally have to use broker-dealers to hold their assets because the drug is still illegal at the federal level.
  • Some pot ETFs are using bank custodians but had to provide additional details upfront including potential securities in which they would invest.

Custodians vs. Broker-Dealers

Custodians are generally large financial institutions that are in charge of holding their customers' securities. As such, they're responsible for safeguarding their clients' assets, whether they are in physical or electronic form. These entities may also provide other services such as tax support, account administration, transaction settlements, and interest payments. Broker-dealers, on the other hand, tend to range in size, varying from small independent operations to subsidiaries of larger investment banks. These entities are in charge of buying and selling different securities for their clients. They can hold stocks just like bank custodians do, and they are also free from federal banking laws.

As mentioned above, traditional ETFs often use custodians, which fulfill several key actions including sending and receiving payments, and holding any cash and/or securities held in the fund's portfolio. But things get a little fuzzy when it comes to the pot industry. That's because questions of custody have been crucial for marijuana ETFs—custodial risk has historically been a significant issue for these ETFs. This is partly due to the fact that many major U.S. banks are reluctant to serve as custodians of funds invested in cannabis.

Although recreational cannabis is legal in more than a dozen states and medically available in many others, the specifics of legalization policy vary from state to state—to say nothing of how marijuana is still illegal at the federal level. That's all to say that it's difficult for a potential custodian bank to assess exactly what this role looks like when dealing with a group of marijuana companies. Even if the cannabis companies were headquartered in Canada, where marijuana enjoys full legalization, U.S. banks still assume responsibility when dealing with the U.S. Department of Justice. In short, a marijuana ETF's bank custodian could face legal trouble as a result of banking laws at the federal level because of its classification as a controlled substance.

If you're interested in investing in the marijuana industry, keep your capital, time horizon, investment goals, and risk tolerance in mind—the same way you would with any other industry.

What Does That Mean for Cannabis ETFs?

The question of custody has been a big one for ETF issuers considering marijuana products. Take the example of U.S.-based ETFMG Alternative Harvest ETF (MJ), which already had custody issues. MJ came about through the transformation of one of ETF Managers Group's preexisting funds. The issuer simply swapped out indexes, circumventing the need for a new custodian. U.S. Bank—the custodian of the original fund—reacted against the change, forcing the ETF to seek out a new custodian after all. The company ended up going with a private custodian—one which didn't have to go through the same federal regulations as a public company.

But because attitudes are changing on a greater scale across the country, more banks may be willing to accept the risks associated with the pot industry. For instance, the Bank of New York Mellon (BK) is the custodian for the AdvisorShares Pure Cannabis ETF (YOLO) and its sister ETF AdvisorShares Pure US Cannabis ETF (MSOS), which were launched in April 2019 and September 2020 respectively. YOLO was able to secure the bank as a custodian after promising the bank and the New York Stock Exchange (NYSE), where it's traded, with information on any of its potential investments.

You May Pay More

There are a few important things that investors should keep in mind, though. Watch out for the potential of added costs involved in participating in these funds. This may happen because of additional audits required by the Securities and Exchange Commission (SEC) depending upon the status of who's holding the securities. The SEC requires custodians for investment vehicles like ETFs to submit to annual audits of the assets contained in those funds if they are not already subject to annual audits. A privately-traded broker-dealer would not normally be subjected to these audits, so that would increase the cost of auditing requirements significantly.

The Bottom Line

Things are certainly changing for the marijuana industry at the state level. But because the drug is still illegal at the federal level, investors need to take a step back and rein in their excitement. Although marijuana ETFs like YOLO and MSOS may have a bank willing to act as their custodian, that may not be the case with every ETF that comes along. Be sure to watch out for additional fees that cover things like surprise audits. And just like any other investment, it's important to do your research before you put any money down.