cannabis ETFs

Although cannabis ETFs like ours have been around for several years now, there still appears to be some confusion as it relates to their impact on the underlying stocks, in particular U.S. plant touching names that are held on swap. Here’s my best attempt to explain:

In a “normal” ETF (i.e. a non swap-based product), creations work as follows:

If you are buying 100 shares of ETF XYZ, there are broadly two types of sellers.

The first is a “natural” seller, a market participant that already holds the ETF for the purpose of generating a return. In this type of trade, there is no impact on the underlying stocks, and the transaction occurs entirely at the ETF level. Easy enough.

The other type of seller is a market maker. When a market maker sells an ETF, they will take an offsetting position in the underlying stocks. They don’t want to take a risk position, but instead arbitrage premiums (or discounts) to NAV. So in our example, they sold you 100 shares of ETF XYZ, and bought the stocks that make up its portfolio. Therefore they are short XYZ, and long the basket. They will repeat this process until they are short enough shares to comprise a creation unit (10,000 shares or higher depending on the fund). In order to reduce their balance sheet exposure, they will deliver the underlying stocks to the ETF in exchange for newly created shares of the ETF. As a result, they are no longer long the underlying stocks (they were delivered to the fund), and the newly created ETF shares offset their short position from when they sold the ETF to you. They are flat, and the ETF has created new shares. Relatively straightforward.

However, swap-based ETFs like U.S. cannabis funds are different. When a market maker has hedged their position as per above, they are long the underlying stocks and short the ETF. But a swap is an OTC bilateral contract between the fund and its counterparty, and swaps can’t be transferred from party to party. Therefore, creations in swap-based products occur via cash. Instead of the market maker delivering the underlying stocks to the fund in exchange for new shares, they deliver USD. But in order to flatten their position at the end of a creation day, they then need to sell their position in the underlying stocks in the open market. Thereafter, they take the USD proceeds and deliver to them to the fund in exchange for new shares of the ETF.

As a result, creations in cannabis funds counterintuitively result in selling pressure on the underlying stocks that cannot be delivered from market makers to the fund. In theory, this could be offset from the ETF turning around and taking the resulting USD to purchase those same securities. However, matters are complicated further by some of these funds being actively managed. Insofar as they deviate from putting the USD to work on a pro-rata basis relative to current exposures, there will be some mismatches versus the market maker.

In aggregate, the above results in elevated volatility towards the end of a day in cannabis funds in which a creation (or redemption, which is simply the reverse) occurs. The same is true for all swap based products (more broadly funds that utilize cash creations and redemptions), however the lower liquidity of the cannabis sector means that impacts are more clearly noticeable.

Hopefully this helps explain a bit!
Note: this is a theoretical framework and in practice market makers may utilize other techniques, but the broad strokes are directionally how it works.