Last Wednesday, Evolve Funds Group Inc. launched the first U.S.-focused cannabis exchange traded fund (USMJ), narrowly beating competitor Horizons Exchange Traded Funds, which launched a U.S.-focused marijuana ETF the following day (HMUS).
The two funds, which both trade on the NEO Exchange, are hoping to tap increasing investor interest in the United States, where state-level cannabis markets are booming and pressure for legislative change at the federal level continues to mount. HMUS, a companion product to Horizon’s popular Canada-focused HMMJ, is taking a passive, index-investing approach to the space. By contrast, USMJ, a companion to Evolve’s SEED ETF, is actively managed. The ETF launched with $1-million under management; as of Tuesday, it had $2.7-million under management, according to Elliot Johnson, Evolve’s CIO and COO, who manages both SEED and USMJ
Cannabis Professional spoke with Mr. Johnson about the new fund. The interview has been edited for length and clarity.
Cannabis Professional: Why are you launching USMJ now?
Elliot Johnson: Our first product SEED did not have any ability to access the U.S. market, and that’s why it has a TSX-listing rather than being on the NEO. We often found it frustrating because we would come across a company, and say ‘oh this is a great opportunity, but it’s U.S. so we can’t have it.’ To some degree, the genesis for the idea of USMJ, was to say, can we build a product that actually explicitly has all the stuff we can’t hold in SEED?
There's a groundswell of new legislation that's going through the system down there, each piece has the potential to be a catalyst for significantly unlocking the value of the companies that are operating. One is the SAFE Act, which would allow companies to have access to national banking services from nationally regulated banks. The STATES Act is the other one; that normalizes federal and state legislation: if the states have said yes to cannabis, then the feds agree. The two of those together, most people will tell you, are the catalyst for moving listings down to the NYSE and institutional investors in U.S. getting into this, whether they be pensions and all the big institutional money managers, or whether it’s big corporate M&A.
President Trump, last summer, said he'd probably sign the STATES Act. He says a lot of things, so I don't know. But a lot of the Democratic contenders for the presidency for 2020, they're supporting this Marijuana Justice Act, and they're really hammering on prohibition from a social justice perspective. It's not impossible to see the Republicans trying to take that chip away from them, by allowing some of this legislation to happen under their watch.
CP: How does the U.S. opportunity compare to the Canadian one?
EJ: You look at California alone, it’s a bigger economy than Canada, and that’s just one of the 10 states that have legalized recreational cannabis. There are U.S. companies that are doing more sales in a single store than some of these large cap Canadian names are doing across the whole country, yet the Canadian names are trading at like 20 times their valuation.
In the U.S., at the state level where it's been legalized, there's a much freer market. You've got the ability to have lots of different brand options, to market, advertise, create a retail experience that's attractive to the customer. You talk to U.S. firms, and they say, ‘yeah, we're making money, and we intend to make a lot of money regardless of what happens with the STATES Act or the SAFE Act or any of those kind of things.’ As long as it continues just at a state level, these multi-state operators (MSOs) are happy to build their operations state by state, and they only become more efficient when legislation changes. We really think the legislation angle has much more to do with investors, which will cause the valuation of these companies to get more in line with the valuations of the companies in Canada.
CP: How do you think about portfolio construction?
EJ: We’re long, we will use options strategies for protection purposes, and we will do securities lending. We look at the market in terms of three categories. We’re trying to hold one category of the larger cap names that we think are likely to be predominant and represent the momentum of the market in the U.S. We have our top weightings in some of the larger U.S. MSO’s, for example, Curaleaf, Harvest Health & Wellness, Cresco Labs, Green Thumb, to pick four from our top 10. The second category are the smaller names, sub- $1 billion in market cap, where we think there’s really good opportunity for them, either as a result of their product strategy, or talking to their management team, or looking at where in the market they’re choosing to plant their flag. An example there might be something like SLANG that has a variety or brands that they’re working on. The third category is ancillary businesses, that’s where the Scotts Miracle-Gro would come into play.
CP: Why are you taking an actively managed approach, as opposed to index investing like HMMJ?
EJ: If you look the performance of SEED, which we have been running now for a year and three months, and compare it to HMMJ, we’ve had significant outperformance. We think it’s because we’re not stuck on a rebalance schedule, just buying everything according to the weights of the index. To give a couple examples from that portfolio: back in August, we heavily weighted our exposure to the larger cap names, because we thought the market was going to run higher into legalization on Oct. 17. That was right, and that gave us some outperformance. But it moved so fast, we completely changed direction at the beginning of October and cut our weighting to that part of the market, two weeks before legalization. All the indicators in our risk management system were saying this thing has run too far too fast, it’s going to revert. That turned out to be right as well.
To pick a single name example, probably the most embattled cannabis company in Canada is Aphria. Back when we were looking at it in the fall, we didn't like it. However, in early December we looked at it and said this thing has absolutely cratered. In the space of three months it went from $25 down to $5, and we said, it's got significant real operations and value there that we didn't think was being represented by the price it was trading at. We put it back in the portfolio, and we were very happy that we did, because over the next two months, it ran back up to $15. If you market cap weighted that, you would have had more exposure when it was at $25, and less at $5, rather than the other way around. That's an example of how index approach to a volatile market can be buying or weighting the wrong thing at the wrong time, because your rule set doesn't account for movements back and forth in the value of a company.
CP: You’re still managing SEED. What do you think about the Canadian opportunity six months into legalization?
EJ: We’re still bullish on Canadian cannabis. This is not an old business, where you can look at somebody and say, ‘oh, that’s never going to grow.’ We think there is still a huge amount of growth. I think, though, it is a market that is prone to short-term bouts of investor euphoria.
Expectations ran a little bit ahead of reality for the Canadian names. But I think people are overly worried about the short-term earnings that have come out in the past quarter. We still don't have retail rolled out across the country, we don't have edibles. I think it is more reasonable to worry about earnings when you have an overabundance of supply and when you have stores full of product being developed and put on the shelf that's not selling. That is not the story right now. Right now the story is people had stars in their eyes about how fast this would happen.
Some of these valuations have assumptions built into them that there’s going to be large global exports from these companies, and you’re starting to see that happen. Europe’s one of the most exciting spots where Canadian companies are at the moment. You have these Canadian companies with expertise and capital getting licenses in European countries and looking to repeat what they’ve done in Canada. I think that there’s a lot of value there, although it’s hard to know how big that’s going to be.
Mark Rendell