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I own the Horizons Marijuana Life Sciences Index ETF (HMMJ). I was thinking of buying the U.S.-dollar version of the ETF (HMMJ.U) and holding it in my U.S.-dollar trading account. My question is what would happen with the distribution? And is it safe?

First, some background.

Some readers might be surprised to learn that an exchange-traded fund (ETF) of largely unprofitable marijuana companies pays a distribution at all. Only one stock in the fund – Scotts Miracle-Gro Co. (SMG-N) – pays a dividend itself, and it doesn’t even grow marijuana. Scotts is included in the ETF’s underlying index because, in addition to distributing lawn and garden supplies, it has a division that sells hydroponic growing equipment.

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If not dividends, where does the cash for HMMJ’s distribution come from? The main source is securities lending. Marijuana stocks are notoriously volatile, which makes them attractive to traders who take long and short positions. The ETF provider, Horizons, makes money by lending the stocks to short sellers, who sell them in the market and then hope to buy them back later at a lower price. (To take a simple example, if a trader borrows shares and sells them for $10 each and the price subsequently falls to $8, he or she can repurchase the shares at the lower price and give them back to the lender, thereby realizing a profit of $2 per share – minus a fee to borrow the shares.)

“Due to a number of factors that include … volatility and the amount of free-market float and available lenders, many of the stocks in HMMJ can be lent out at higher-than-average lending rates compared to what is available for traditional large-cap equities,” says Mark Noble, senior vice-president with Horizons.

HMMJ paid its first cash distribution, of about 22.4 cents a unit, in October. It has since paid two more quarterly cash distributions – about 9.1 cents in January and 28.2 cents in April – for a total of about 59.7 cents. (It also had a non-cash reinvested distribution of 21.8 cents in January.) Based on the three quarterly cash payments, HMMJ’s trailing yield is about 3 per cent. The quarterly distribution is volatile because it is affected by many factors, including cash inflows to the fund and mergers involving companies in the sector. Takeover deals create arbitrage opportunities that involve selling short the acquirer’s stock and going long on the target company, and the ensuing demand for borrowed shares drives up the rates Horizons can charge, Mr. Noble says.

But Horizons cautions that the distribution is not a sure thing: “Distributions for HMMJ/HMMJ.U are declared at the discretion of Horizons ETFs and may not be announced with a set frequency. With a limited operating history, Horizons ETFs believes that the disclosure of an annualized yield for the ETF at this time would be misleading to unitholders,” the company says.

In other words, HMMJ isn’t like a bank stock or a utility where investors can be fairly certain that a dividend will get paid every quarter and rise gradually over time.

Now, to your question about the U.S.-dollar version of the ETF. HMMJ.U is aimed primarily at U.S. institutional and retail investors who want to buy and sell in their home currency. For Canadian investors, it doesn’t make a lot of sense to buy HMMJ.U because brokers typically charge a hefty markup to convert Canadian dollars to U.S. dollars and vice versa.

Whether you hold HMMJ or HMMJ.U, the distribution is declared in Canadian dollars. What’s more, if you hold HMMJ.U in a U.S.-dollar account at a Canadian brokerage, the broker will likely convert the Canadian-dollar distribution to U.S. dollars before paying it to you, so you won’t be able to avoid the currency-conversion costs. So, if you’re a Canadian who wants to invest in the ETF, the plain-vanilla HMMJ probably makes more sense. (Just to be clear, I am not recommending marijuana stocks or ETFs, as they do not fit with my dividend growth strategy.)

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The tax consequences for Canadian investors are also the same regardless of which version of the fund you own. Horizons provides a detailed breakdown of HMMJ’s tax characteristics on its website under “2017 Distribution Summary.” The 2017 payments (which, for tax purposes, include the cash and non-cash distribution paid in January because the record date was in December) consists of foreign income, capital gains and other income. There is also a small amount of foreign tax withheld – presumably from Scotts, the one company in the ETF that pays a dividend.

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