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Pros and cons of investing in naughty themes

When it comes to investing, vice can sometimes be nice.

Owning so-called sin stocks, such as companies involved with tobacco, alcohol, casinos, arms and cannabis, potentially can be rewarding. While more exchange-traded funds (ETFs) offer exposure to this naughty niche, investors need to check under their hood and assess their risk tolerance before jumping onboard.

Alcohol and tobacco stocks are particularly compelling because "they are recession-resistant – if not recession proof," says Dan Ahrens, chief operating officer of U.S.-based AdvisorShares Investments and author of Investing in Vice. "They have been steady performers for decades and are very good dividend payers. … Tobacco also has the largest profit margin of any consumer product."

Mr. Ahrens's background in this niche stems from a stint as the first of several managers to run the USA Mutuals Vice Investor mutual fund launched in 2002. Since inception, this fund, which invests in the alcohol, tobacco, gaming and defence industries, has outpaced the S&P 500 Index, including dividends.

Now, he is the portfolio manager for the relatively new actively managed U.S.-listed AdvisorShares Vice ETF, which invests only in tobacco, alcohol and cannabis-related names. "There is going to be a big overlap between the alcohol and tobacco industries and legal cannabis," he predicts.

For instance, U.S. beer and wine giant Constellation Brands Inc. last fall bought a near 10-per-cent stake in Canadian marijuana producer Canopy Growth Corp. to collaborate on cannabis-infused drinks.

Because marijuana is not legal federally in the United States, his ETF invests only in ancillary companies such as AbbVie Inc., which markets a cannabis-based drug, and Scotts Miracle-Gro Co., whose hydroponic business allows cannabis and other plants to grow indoors.

When investing in U.S.-listed ETFs holding cannabis stocks, investors need to "look under the hood" for regulatory risk, Mr. Ahrens warns. Some U.S. states have legalized marijuana, but "it is federally not legal to invest directly in marijuana companies," he said. "Domestic [U.S.] funds could be forced to divest from their illegal investments. … It is different in Canada, of course."

ETF Managers Group LLC, which markets the Spirited Funds/ETFMG Whiskey and Spirits ETF, launched the ETFMG Alternative Harvest ETF in December. This is the first U.S.-listed marijuana fund and was converted from an existing real estate ETF.

Because this fund tracks some Canadian cannabis companies, U.S. Bancorp is reviewing whether to remain as the ETF's custodian to avoid running afoul of the law. If it walks away, and a replacement is not found, this ETF may be liquidated.

More Canadian-listed cannabis ETFs, meanwhile, are rolling out to get ready for legalization of recreational marijuana by summer.

Horizons Marijuana Life Sciences ETF was launched last year, while its sister, Horizons Emerging Marijuana Growers ETF, is set to list tomorrow. Unlike their index-oriented peers, Redwood Marijuana Opportunities ETF and Evolve Marijuana ETF use an actively managed strategy for their cannabis funds.

While the marijuana niche has been a hot play recently, National Bank Financial ETF analyst Daniel Straus cautions investors to approach the more volatile cannabis equities differently from their established sin-stocks peers.

The alcohol and tobacco industries have been very profitable, and their stock valuations are typically lower than the broader market possibly because some investors avoid them, he said. "They are … a source of value."

But cannabis stocks are an outlier because there is so much speculative interest in them, he said. "There is a lot of uncertainty and a lot of very high valuations. Some of these companies have billion-dollar market-caps, zero revenue and negative earnings. … Any future growth may be priced in [the stocks]."

Cannabis ETFs are suited to aggressive, growth-oriented investors with a time horizon of 10 to 20 years, and who could sustain a total loss, he suggested. While these ETFs are risky, there is also possibility for "enormous future returns."

For instance, the Horizons Marijuana Life Sciences ETF, which listed at $10 a unit last April, more than doubled to the $24-per-unit range last month. It has since pulled back to $18 amid the market downturn.

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