On December 11, BNN Bloomberg reported the launch of the first-ever US leveraged ETN (exchange-traded note) for the cannabis sector. The MicroSectors Cannabis 2x Leveraged ETN is slated to start trading under the ticker symbol MJO on December 18 on the NYSE Arca.
Connecticut-based REX Shares LLC designed this leveraged cannabis ETN. Scott Acheychek, the president of REX Shares, claimed the ETN would give investors exposure to the entire cannabis ecosystem. The ETN would also track an index that tracks five cannabis industry subcategories—pharmaceuticals, cultivators, industrial hemp, ancillary businesses, and testing and analytics services.
REX Shares LLC has designed an unleveraged cannabis ETN, the MicroSectors Cannabis ETN. This ETN would trade under the ticker symbol MJJ. The Bank of Montreal issues both of these ETNs.
What is an ETN?
According to CNBC, ETNs are senior, unsecured debt securities issued by major investment banks. However, the issuer does not guarantee these securities. ETNs trade like stocks on major exchanges during normal trading hours. These investment vehicles combine the characteristics of bonds and ETFs (exchange-traded funds).
Similar to an ETF, the return of an ETN depends on the performance of the index or the benchmark it tracks. The ETN’s price fluctuates throughout the trading day, similar to that of stocks and indexes.
According to Fidelity, unlike ETFs, ETNs do not own the securities of the index they track. An ETN behaves like a debt security where the issuer pays investors at maturity the full value of index minus management fee. However, these investment vehicles do not pay interest to investors.
What are the benefits of ETN investing?
According to Fidelity, ETNs help reduce tracking errors or the difference between the value of the portfolio and the index. These engineered products mimic the underlying index by deploying several derivative instruments such as futures, options, and swaps.
In the case of ETFs, issuers may face problems with a higher number of securities or illiquid securities in the index. This is because they have to actually purchase the securities in the proportion they are present in the index.
In the case of an ETN, it is not the investor’s concern if the bank is not able to correctly match the index. The bank remains liable to pay investors depending on the performance of the index.
Fidelity also explains that ETNs do not trigger short-term capital gains tax payments. These financial engineered products do not have actual stocks or bonds as underlying instruments. So, they make no periodic payments such as dividends or interest. Finally, ETNs are one more way of making complex investment vehicles available to the retail investor.
Cannabis ETN investments can be highly risky
ETN investors see a significant level of exposure to issuer or credit risk. The ETN has value only if the issuer can fulfill its obligation. So, the value of the ETN changes not only with the performance of the tracked index but also with changes in the credit rating of the issuer. Investors of the leveraged cannabis ETN would rely on the creditworthiness of the Bank of Montreal.
The MicroSectors Cannabis 2x Leveraged ETN is essentially a leveraged bet on the directionality of an index representing the overall cannabis sector. This implies that the ETN would essentially double up the gains and losses realized on the tracked index. As a result, investors are exposed to significant volatility.
If an uptrend occurs in the cannabis sector in 2020, this could be an excellent entry point for ETN investors. However, the chances of a rapid turnaround for the sector remain slim. Currently, the cannabis sector is swamped with challenges such as the vaping crisis, FDA warning on CBD products, cash crunch, and lack of profitability.
Prominent cannabis players such as Aurora Cannabis (ACB), Canopy Growth (CGC), Cronos Group (CRON), and Aphria (APHA) have lost significant market value year-to-date. Wall Street doesn’t expect ACB and CGC to become profitable in 2020. Against this backdrop, the leveraged ETN can magnify any further losses in the cannabis sector.
Finally, the MicroSectors Cannabis 2x Leveraged ETN investors may also face liquidity risk.