By Rachel Evans and Annie Massa
(Bloomberg) --Investing in getting high could turn out to be the ultimate downer for buyers of a popular new exchange-traded fund.
The ETFMG Alternative Harvest ETF, which has raised more than $350 million this year under the MJX ticker, faces an abrupt closure if the institution charged with holding its assets pulls the plug and a replacement isn’t found.
It’s a big “if’’ -- custodians tend to be in it for the long haul -- but U.S. Bancorp is actively reviewing whether it will remain the fund’s custodian after the ETF shifted strategies late last year and went from buying Latin American real estate companies to cannabis producers, a person familiar with the matter said, asking not to be identified because the details are private.
That could prove a rude awakening for anyone who’s piled into the fund since then. Custodians are typically allowed to terminate their contract with an ETF issuer after a notice period of about 90 days, depending on their agreement. Minus a custodian -- a legal requirement under the Investment Company Act of 1940 -- a fund’s board would be pushed to liquidate the ETF, with shareholders splitting the proceeds.
“The securities have to be there and they have to be held by one of these entities,” said Kathleen Moriarty, who helped set up the first ETF in 1993 and is a partner at Chapman & Cutler LLP. “If no one proper would hold them then they would have to liquidate.” Moriarty is not working with either this fund or on any rival pot ETFs, and was not commenting specifically on MJX.
‘Back and forth’
Both ETF Managers Group, which runs the fund, and U.S. Bancorp declined to comment on whether a termination letter had been sent. Kim Mikrot, a spokeswoman for U.S. Bancorp, also declined to comment on whether the fund’s custody was under review.
“We had a number of back-and-forth letters that are covered by a confidentiality letter that I can’t talk about but we have been negotiating the services for all of our funds for the last 12 months,” ETFMG’s Chief Executive Officer Sam Masucci said last week. He added that the firm is “continuing to work with U.S. Bank” and attributed the “rumors” about custody issues to competitors.
ETFMG entered a five-year custody agreement with the lender in late December, filings show. Masucci was not available to comment on the U.S. Bancorp review when contacted through a spokeswoman on Tuesday.
A spokeswoman for NYSE Group Inc., which lists MJX on its NYSE Arca platform, declined to comment on the fund. ETFs on the exchange are required to confirm once a year that they comply with all regulations that apply to their fund. In the event of a so-called “notifiable event” -- anything major that could affect the fund’s operation -- the ETF has to notify the exchange and public. In addition, the exchange can audit funds it’s concerned about.
Being a custodian for a pot ETF is tricky for an institution like U.S. Bancorp to navigate. On the one hand, investor demand for the product is strong, and a custodian, which is often also the administrator and transfer agent, receives a fee for those services.
For example, U.S. Bancorp received $27,887 in the year ended Sept. 30 for serving as administrator for the previous incarnation of the ETF, with compensation based on the fund’s average daily assets and an annual minimum, documents show. At the time, the Latin American real estate ETF averaged just $3.5 million under management. MJX currently has about $410 million in total assets.
But, a marijuana fund’s holdings also pose a reputational -- and possibly legal -- risk, particularly with a potential federal crackdown on some states’ legalization efforts. MJX tracks a measure that “will not include any companies that are in violation of any United States federal or state laws,” documents show. Its current holdings include Canadian medical marijuana companies Canopy Growth Corp. and Aurora Cannabis Inc., which recently agreed to acquire CanniMed Therapeutics Inc., another holding.
At least three other issuers that contemplated starting pot ETFs ran into trouble lining up custodians, people familiar with the matters said. ETFMG bypassed those start-up issues by converting an existing fund. MJX will change its ticker to MJ from Feb. 9, according to a filing this week.
Of course, U.S. Bank could decide in favor of ETFMG. Or another custodian could step in. CIBC Mellon Trust has custody of the Horizons Marijuana Life Sciences Index ETF in Canada, where weed will become legal for recreational use later this year. In the U.S., Bank of New York Mellon is looking after the AdvisorShares Vice ETF. That fund can invest in companies with “current or future revenues from cannabis-related business,” although its holdings currently focus more on alcohol and tobacco.
Technically, ETFMG could even decide to be custodian for the fund itself, although that route is subject to strict rules and surprise audits that lawyers say make it almost untenable for most providers.
What’s clear is that there’s a lot of money at stake -- for investors, for the manager and for a custodian. All of the ETFMG-branded funds are currently administered by, and custodied with, U.S. Bank.
“A number of competitors of theirs both in the U.S. and outside have reached out to us to say, ‘Look, we’d like to talk to you about not just moving MJX but your entire business,’” said Masucci, indicating that a wannabe custodian would have to look at a package deal. “The benefit really accrues mostly to the operations, which then accrues to investors, if you use one service provider. If you’re not comfortable with that provider then you probably shouldn’t have any of your funds there.”
To contact the reporters on this story: Rachel Evans in New York at [email protected] ;Annie Massa in New York at [email protected] To contact the editors responsible for this story: Jeremy Herron at [email protected] Eric J. Weiner, Adam Haigh