People's attitudes about pot are changing dramatically, with 68% of American adults in a recent Gallup poll supporting the legalization of marijuana in the U.S, up sharply from only 12% more than five decades ago. Despite being classified as a controlled substance at the federal level in the U.S., more states are taking the opposite route by legalizing marijuana. As of April 2021, 16 states and Washington, D.C. have legalized recreational marijuana use, while 43 have legalized cannabis or related products for medical use. 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 changes in cannabis legalization sweeping the nation. Cannabis ETFs provide investors with exposure to companies that deal directly and indirectly with the growth of marijuana plants, as well as software, technology, and other parts of the industry. The best-performing cannabis ETFs may provide investors with substantial returns. But because of the complicated issues surrounding the legality of cannabis, there are still challenges these ETF issuers face. A major one, notably, is 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. 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 may have to use broker-dealers to hold their assets because the drug is still illegal at the federal level in the U.S.
  • Some pot ETFs are using bank custodians but have to provide additional details upfront, including about 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, by contrast, 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 the situation is far less clear when it comes to the pot industry. Questions of custody have been a key issue when it comes to marijuana 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 now in more than a dozen states and medically available in many others, the specifics of legalization policy vary from state to state. If that were not complicated enough, marijuana is still illegal at the federal level. That makes it 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 involving marijuana products. Take the example of U.S.-based ETFMG Alternative Harvest ETF (MJ), the largest cannabis ETF by assets under management as of this writing, at $1.8 billion. MJ came about through the transformation of one of ETF Managers Group's preexisting funds, which focused on Latin American real estate. Instead of using the usual 'filing-to-launch' process, the issuer simply swapped out indexes, circumventing the need for a new custodian. U.S. Bank—a federally chartered bank and the custodian of the original fund—ended its relationship with MJ without publicly stating a reason. Instead, broker-dealer Wedbush Securities Inc. became custodian. The Amplify Seymour Cannabis ETF (CNBS) has followed a similar path. This fund utilizes Cowen Execution Services LLC, another broker-dealer, as custodian.

Because attitudes toward marijuana are changing 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 fund, AdvisorShares Pure US Cannabis ETF (MSOS). MSOS is newest marijuana ETF, having launched in September 2020. While YOLO wasn't the first marijuana ETF, it was the first New York Stock Exchange (NYSE)-listed marijuana fund backed by a large custodian institution. YOLO was able to secure the bank as a custodian after promising the bank and the NYSE, where it's traded, to provide information on any of its potential investments.

To avoid running into potential legal issues, one option for cannabis funds is to focus exclusively on: companies indirectly related to cannabis production, companies specializing in medical cannabis research, or companies involved in financing the industry. The Global X Cannabis ETF (POTX), launched in September 2019, takes this approach. Global X specifies in their prospectus that POTX will only invest in companies that supply products and services in the cannabis industry if those companies operate legally under federal, state, and local laws. While some companies may be able to operate legally at the state and local level, they may not be able to do so at the federal level, and this would eliminate them from consideration for POTX. POTX engages Brown Brothers Harriman & Co. as custodian.

You May Pay More

While the issue of custodian vs. broker-dealer may not seem directly relevant to a potential cannabis ETF investor, there are a few important things that investors should keep in mind. 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. The cannabis ETF space is still small, with fewer than a dozen funds launched so far. 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.