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A new market high: First ETF to target marijuana stocks

As the Trump administration considers renegotiating the historic trade agreement with its North American neighbors, Canada is pushing ahead with a trade that places it well ahead of the United States: a first-of-its-kind exchange-traded fund that invests in medical marijuana stocks. Whether the pioneering effort is good for investors should spark debate.

For investors who believe that the marijuana market will be a booming sector, the Horizons Medical Marijuana Life Sciences ETF (HMMJ), which starts selling on the Toronto Stock Exchange on Wednesday, offers a way to invest without taking on individual company risk. However, the ETF only holds a total of 14 stocks, and while billed as a global fund, 10 holdings are Canadian-based. The medical marijuana industry is more developed in Canada than in other nations, and cannabis could soon become legal for all Canadian adults.

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David McNew | Getty Images

While most of the limited number of stocks are producing pot for medical use, the ETF is also stretching its definition to get to 14 holdings. Three of the ETF's 14 holdings aren't pot growers. Insys Therapeutics and Zynerba Pharmaceuticals are biotech firms that are creating synthetic THC.

Alan Brochstein, a chartered financial analyst and founder of 420 Investor, a subscription-based service for investors interested in publicly traded cannabis stocks, noted on his website: "Several of the selections are odd. INSY, which is under heavy scrutiny from the government for its alleged marketing practices and is also restating its financials, and ZYNE are biotech companies engaged in the development of drugs derived synthetically and not from botanical cannabis. Rather than being 'medical marijuana' companies, their success may come at the detriment of the medical cannabis industry."

Insys, which makes an opioid painkiller that is much more powerful than morphine, was the subject of a CNBC investigation last year that resulted in the exit of its CEO.

The ETF also holds Scotts Miracle-Gro, which is a $5 billion market-cap fertilizer company. "It's a cannabis play buried in a large fertilizer play," Brochstein wrote.

Horizons holds these companies, including GW Pharmaceuticals, which also creates synthetic THC, because it wants to have exposure to all parts of the marijuana industry, said Steve Hawkins, president and co-CEO of Toronto's Horizons ETF. Any company that has business activities in the pot sector would apply for inclusion in the North American Medical Marijuana Index, which is what the ETF is based on.

As an investment theme, marijuana stocks aren't as outlandish an idea as they once were, Brochstein said. When he started following pot stocks in 2013, "it was the Wild West." While there still are a number penny stocks, there are several legitimate businesses with long-term potential, he said.

Billions are also spent on cannabis every year. In the United States, marijuana sales were expected to top $6.7 billion in 2016, up 25 percent from a year earlier. Globally, it's estimated that $150 billion is spent illegally on the drug every year. As more countries legalize weed, the better these stocks will do. Some of the fund's stocks have done well this year, including Vancouver's Aurora Cannabis and Ontario-based Aphria, which are up 15 percent year-to-date, according to Google Finance.

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One of the issues with the ETF itself is that the holdings are trading at high valuations even though most don't have any material earnings yet, meaning they can't trade on a price-to-earnings basis. Instead, many operations are trading at 15 to 20 times price-to-sales, which is expensive, Brochstein said, and may not even be all that accurate.

"Sales are being priced for post-legalization, which might only happen in 2019 or 2020," he noted. "These estimates are based on the production from places that don't even exist yet. Capital needs to be put into productive capacity, but that productive capacity needs to scale up. It'll be interesting to see how that plays out."

"Sales are being priced for post-legalization, which might only happen in 2019 or 2020.  These estimates are based on the production from places that don't even exist yet." -Alan Brochstein, a chartered financial analyst and founder of 420 Investor

Those who want to hold a niche industry ETF like this one must know that anything can happen in the short term, said Todd Rosenbluth, director of ETF and mutual fund research at CFRA Research. Thematic ETFs, especially ones that cover young industries, could see ups and downs as the sector works its way through its growing pains, he said.

"It can't just be an interesting concept," Rosenbluth said, though he could not provide commentary specific to the new marijuana ETF. "The narrower the investment theme, the more can go wrong if demand for the underlying securities doesn't materialize."

Hawkins said that investing in this industry is a high-risk, high-reward proposition. While companies are maturing, the sector is at the whim of governments and it's still unclear what rules and regulations will be placed around the sale of pot.

With a 0.75 percent expense ratio, Brochstein said this ETF may be better for investors who want to put smaller amounts of money into the sector. Put too much and the fee, plus any transaction fees, starts to add up. "It can be expensive if you have a lot of money in it," he said.

Horizons is marketing the ETF to do-it-yourself investors rather than investment advisors and says there's been more interest in this product than any other ETF the company has ever put out. Hawkins says it's for people who want to add a growth sector to an already diversified portfolio and for those who think long-term. "You don't have to be a marijuana user to be able to want to invest in this," he said. "It's for people who can see the growth prospects of the industry."

Despite his concerns, Brochstein is positive on the ETF. "The need for a stock vehicle is great. And the market has matured now to where it makes sense to have one," he said.

Hawkins compares companies in the marijuana industry to the early stage internet operations of the 1990s. "It's a young industry, and it's evolving daily," he said. "It has the growth that internet companies once did."

Put that in your pipe and smoke it.

— By Bryan Borzykowski, special to CNBC.com

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