ETF Expert Corner

Kris Monaco Spotlights Index Underlying ETFMG Alternative Harvest ETF (MJX)

January 16th, 2018 by ETF Store Staff

Kris Monaco, Managing Partner at Level ETF Ventures, spotlights the index behind the recently launched ETFMG Alternative Harvest ETF (MJX), the first marijuana-focused ETF in the U.S.



Transcript

You can listen to our interview with Kris Monaco by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: Our guest today is Kris Monaco, Managing Partner at Level ETF Ventures. They're behind Prime Indexes, and Prime Indexes manages the indexes for several noteworthy ETFs, including the recently launched ETFMG Alternative Harvest ETF, ticker symbol MJX. That's the first ever marijuana-focused ETF in the U.S. They also run the index behind the very popular ETFMG Prime Cyber Security ETF, ticker symbol HACK. And then they manage indexes for several other ETFs as well. Kris is joining us via phone today from New York. Kris, as always, a pleasure to have you on the program.

Kris Monaco: Well, thank you very much. It's great to be back again.

Nate Geraci: Kris, let's start with the index underlying MJX, the Prime Alternative Harvest Index. Walk us through the basic construction here in terms of holdings, weightings, anything else noteworthy.

Kris Monaco: It's a little complex, but I'll distill it. The Prime Alternative Harvest Index is a global index of about 30 components and the way it begins is first with essentially a dragnet of research - and it's an exhaustive search of all marijuana and related companies by reviewing public filings, disclosures and other descriptions from those companies. That's the first step and that produces quite a large population of components and so the next step is we filter out certain companies that are below 200 million in market cap. Also, we take liquidity into account by removing companies that have less than $500,000 traded daily on an average daily basis over the last three months. So that's the first step and that distills it to some degree, but then what we do is we broadly categorize the companies based on their relevance by calling them either primary or secondary beneficiaries. And what that means is that a primary beneficiary is one that derives more than 50% of its revenues from cannabis-focused and cannabis biopharma activities or it describes as part of its primary business as being engaged in those activities. And then the remaining companies are called secondary beneficiaries. So now that we have those two categories, we determine the aggregate weighting of each of those categories and then we assign them to a component that our proprietary classification system - which is what we call the prime cannabis classification system. That includes cannabis focused companies or companies that are engaged in cultivating, processing and distributing cannabis. Cannabis biopharma, which focuses on companies engaged in creating cannabinoid drugs whether they're pure botanical extracts or actually synthetic cannabinoid drugs. And then tobacco companies. And this involves companies that are engaged in producing cigarettes and cigars and other like products. Tobacco-related, these are companies that produce some of the components for those cigarettes. And agrochemical and these are companies that make certain fertilizers and hydroponic equipment. And in the end produces that portfolio that's reconstituted on a quarterly basis. It roughly has about 30 stocks in it.

Nate Geraci: Kris, you mentioned that this is a global ETF. Just high level, what does that breakdown look like?

Kris Monaco: Yeah that breakdown, it's still primarily North American, so Canada is the largest weighting and I guess that makes sense considering all the news that we've been reading lately and how far ahead Canada is in terms of legalizing it at the national level. So roughly 10 components are Canadian with a weighting of about 47% and then the next tier is U.S., and so there is 12 stocks that are in the U.S. and that's about a 30% weighting. The UK is next with 3 stocks and roughly 9% and then there's other European stocks and also a couple of Asian stocks that comprise the remaining amount, about 10-12%.

Nate Geraci: You mentioned that this index does include traditional tobacco companies, companies like Philip Morris, Altria. Can you expand on the investment rationale to own those companies as it relates to marijuana?

Kris Monaco: Yeah, this has been a great debate and I love having it because I think what people may not realize when they first see the portfolio is that the entire tobacco industry is built on recreational smoking of leaves in paper tubes and that's what they do. So when you think of it in that context, what else will tobacco companies do when recreational consumption of cannabis becomes more broadly legal? As a matter of fact, big tobacco isn't even waiting for that to happen. Just about every major tobacco company has acquired an e-cigarette or an e-vapor company or has developed their own technology in that space and that technology is considered to be the preferred delivery mechanism or the preferred delivery system for cannabis users.

Nate Geraci: Kris, you mentioned cannabis potentially becoming more broadly legal at some point down the line. Look, we're certainly no experts on the regulatory side of the equation as it relates to marijuana, so can you just explain for us the general legalities surrounding what some of these companies do? In other words, what's the distinction between a "legal" and an "illegal" company and how different is it in the U.S. versus Canada?

Kris Monaco: Yeah and that really is the primary debate here because it is a little bit of a gray area. We look at filings of companies and what we can glean from those companies, if they're engaged in certain activities that we determine to be illegal at the federal level. So the way it happens to be structured now, or at least cannabis used now in the U.S., is that certain states have decriminalized cannabis. But at the federal level, it still remains a Class 1 drug and so that's the big debate right now where states are actively moving forward to decriminalize its use, yet at the federal level it's still difficult to engage in certain banking activity or financing activity because a lot of those traditional businesses are afraid to get involved in the industry for fear of some consequence at the federal level.

Nate Geraci: Could you maybe spotlight a top marijuana company or two held in this index? Just give us a general idea as to exactly what they do?

Kris Monaco: GW Pharmaceuticals is one my favorite companies to continue following and that's because it is the first company to develop a pure botanical drug using cannabis. And it's meant to treat multiple sclerosis, so it's a very dangerous disease that we all know about and this is the first time that a company has developed this pure botanical drug based on cannabis. It's a UK company, has roughly 30-35 million in revenue and has a deal with Bayer to distribute the drug broadly overseas. Now, a lot of these benefits have not come to the U.S. because of the issues that I just mentioned, but here we have a company that's engaging in this research to just help this one drug, but we already know that there's a lot of other medical research now that are looking at Post Traumatic Stress Disorder, Alzheimer's disease, pain management and cancer treatment. So the uses are really starting to broaden now and I think we're going to see a lot more research, which is driving this notion that cannabis is quickly losing its stigma in the U.S.

Conor Kelly: Kris, this is Conor Kelly, a quick follow-up question. I would think with the opioid crisis we have in this country that the cannabinoid idea in the pain management would become more attractive and is gaining steam I would hope?

Kris Monaco: You're absolutely right, that is a great point and a lot of people may not realize the incredible epidemic we have in this country. And I think it was the combination of studies done between the CDC and others where over 90 Americans die every day from fatal overdose. And that's because a lot of people consider that prescribed drugs to be the gateway into that dependency. And now, here you have the potential for another controlled substance that has nowhere near the risks of dependency and no risk of a fatal overdose. So this is seen as a huge opportunity for biopharma companies to develop drugs that would basically be opioid replacements.

Nate Geraci: Our guest today is Kris Monaco, Managing Partner at Level ETF Ventures. Kris, in terms of the investment opportunity, what about current valuations in this space? There's clearly a lot of interest in marijuana-related companies. There's no question this is a tremendous growth area. Are valuations extended at all or are they simply reflective of the opportunity here?

Kris Monaco: Well, as an index provider, we are not looking at the valuations compared to peers because it's hard to judge especially in this case. When we create emerging thematic ideas or emerging industry ideas, it's hard to place a valuation on these because the growth is hyperbolic. And, in this case, we're going to see a lot more states legalize this because of what happened very early in the year with Attorney General Sessions rescinding what's called the Cole Memo. And I think that became the galvanizing point among states to begin to accelerate their effort to decriminalize this and what that means is that the more that becomes legal in the U.S., and I think the cat is out of the bag now, it's going to be very hard to enforce this at the state level. The more these companies will begin to cultivate and distribute and process and the more medical research will be done that will allow for cannabinoid drugs to be prescribed. So I think it's hard to tell valuations because of the legal uncertainty, but it seems that the momentum is there now and will probably drive a lot of these opportunities for these companies to continue generating revenue.

Nate Geraci: Alright, lastly before we move on here because I do want to briefly touch on HACK, what about the size and universe of companies in the marijuana space? I've seen some concerns that it's really a pretty small universe in terms of investible marijuana-related companies. Are you concerned at all about potential capacity issues, just not having enough to include in the index?

Kris Monaco: We always monitor the population. We always take liquidity into account. That's very important, that's an excellent point. Yes, it's always a good point, but there are more and more companies that are beginning to broaden their business. Like I said, the tobacco industry will soon be in the business, although I would argue that it is already in the business. But we always continue to monitor the size and liquidity of the companies and within the index design itself. We make sure to take that into account so we're not overloading some of the components. But yet the liquidity is increasing because of the focus on these companies and there are quite a few more that haven't made it into the index, but will likely make it into the index over the coming months just because their liquidity is increasing and their investment pool is broadening as well.

Nate Geraci: Again, we're visiting with Kris Monaco, Managing Partner at Level ETF Ventures. Kris, I mentioned HACK. Prime Indexes also runs the index behind the ETFMG Prime Cyber Security ETF. That ETF has over a billion dollars invested in it. It's the most popular way to play Cyber Security. For our listeners who aren't familiar with this ETF and the index underlying it, walk us through it. What does the index hold, how is it weighted and maybe provide a top holding or two?

Kris Monaco: Sure. This is a global index as well, it has roughly 45 components. And the breakdown across the globe, it's still predominantly U.S., so there's 30 components that are U.S. representing about three quarters of the weight of the index. And then it gets pretty interesting. So the UK is next, around five components and 8%. And then we jump to Israel, which has quite a few cutting-edge technology companies. As a matter of fact, there's a fund devoted to that separately that focuses on Israeli tech and quite certainly we look at a lot of the Israeli tech companies as drivers in the cyber defense space. And then Japan, roughly 5%, the Netherlands, South Korea and Finland, but those have much smaller amounts. Nevertheless, the diversity is changing all the time and broadening. So that's the constituency in terms of the global nature of it, but again, just like the Prime Alternative Harvest Index, everything starts with this exhaustive screen of company filings and statements and other descriptions where we look for their business activity as it relates to cyber defense. We screen based on a minimum market cap of 100 million dollars and then we classify each of the companies as either a cyber defense architecture company or a cyber defense application provider. We determine the weighting of each segment by summing up the market capitalization of each company in its respective category and then we divide that by the entire market cap of the whole cyber defense universe. After that, we equally weight with each category, but we adjust the weightings to account for how market cap and liquidity may impact those stocks. So just like MJX, there are certain factors in here as well that we use to account for either low market cap or low liquidity that's traded.

Nate Geraci: Kris, in terms of the potential investment opportunity, I think just about everyone understands the seriousness and importance of cyber security. I actually saw just last week the new Vanguard CEO, Tim Buckley, he actually said cyber security was his number one priority. But, just briefly here, paint the investment opportunity for us. Given that everyone knows how important it is, what's the opportunity moving forward?

Kris Monaco: Yeah, and he should be because the fact is that there are more mobile connections than there are people. And there are billions of devices that are connected to the internet now and more companies are dependent on cloud-based solutions. So all of this creates a very fertile target for hackers and organized criminals. And let's face it, there is just this asymmetric resource issue where you have virtually zero unemployment in the IT security and cyber defense space, but you have a very easy entry for very skilled, very technical oriented folks that find it easy to set up shop and to go after some of these points of infiltration. So there's a lot of money to be made, but I was reading I think it was a Gartner Report, that estimates this year IT security and cyber defense spending will be just below 100 billion dollars - so that's an enormous business. And there are different crimes that are actually being identified now, different types of trends that haven't existed several years ago. So this will always be in the news, this will never go away.

Nate Geraci: Kris, we have just a few minutes left here. You have a long track record of being involved in ETF launches. Your firm is involved at the ground level in helping companies launch new ETFs, obviously you're behind building indexes. I'd love to just hear your thoughts surrounding ETF innovation. What are some areas of opportunities, perhaps some challenges, just what do you see moving forward for ETFs at a very broad level?

Kris Monaco: Well, I think the barriers to entry are very low, but the barriers to success are very high. And what that means is that the industry has evolved in such a way and has become so cost efficient that it becomes relatively easy now to create or launch an ETF, but it's very hard to promote that ETF and to make it successful after it's launched. So the analogy I like to use is that it's quite easy to make a baby, but it's a lot harder to raise one after it's born. And that's certainly what happens in the ETF space. We've seen a lot of funds that have been launched that the intentions were good, it may make sense, it may or may not resonate with investors, but that's where marketing comes in and I think a lot of new sponsors may underestimate the need for marketing and research and distribution. But innovation will continue and I think we'll see a lot of new emerging industry and thematic ideas, especially emerging tech ideas, come to market because the classical industry classifications are not evolving. A lot of people think about the traditional industry classifications, they are very broad and generic and nebulous and I think people, especially younger investors, want to see investments themes that they are familiar with, that they are following because that's what's topical. And that's what we focus on.

Nate Geraci: Kris, I think that's very well put and we are out of time, so we'll have to leave it there. As always, we greatly appreciate you joining us on the program today. Thank you.

Kris Monaco: Always a pleasure, thanks guys.

Nate Geraci: That was Kris Monaco, Managing Partner at Level ETF Ventures and you can learn more about Prime Indexes by visiting primeindexes.com.