BOTZ - AIO: Appealing AI Theme But Income Strategy Could Suffer

2023-09-11 16:33:25 ET

Summary

• Virtus Artificial Intelligence & Technology Opportunities Fund holds unconventional AI-related companies in its top holdings.
• In this case, AI is not limited to the IT sector and has applications in healthcare, finance, transportation, manufacturing, and education signifying capital gains as productivity gains come to the fore.
• On the other hand, its multi-asset income-generating strategy, which also includes high-yield bonds in addition to equities, may be risky.
• For those with a long-term investment horizon, it may not be the right time to start an investment in AIO.

Virtus Artificial Intelligence & Technology Opportunities Fund ( AIO ) is different from peers WisdomTree Artificial Intelligence and Innovation Fund ETF ( WTAI ) or Global X Robotics & Artificial Intelligence ETF ( BOTZ ) as firstly, it is a CEF (closed-ended fund), and second, it does not include some of the companies you might expect as part of its top holdings. One example is Alphabet ( GOOG ), which likes to brand itself as an AI-first company. Instead, there are Deere & Company ( DE ) which mostly manufactures agricultural machinery, and UnitedHealth Group ( UNH ), or names that are not normally associated with artificial intelligence.

Moreover, since technology companies directly involved in AI like Microsoft ( MSFT ), Nvidia ( NVDA ) or Oracle ( ORCL ) do not provide the same level of distribution to shareholders as energy companies, the aim of this thesis is to show that the near-10% dividend yield paid by the Virtus fund may be unsustainable which explains my hold position.

First, I explore the reasons why artificial intelligence may not exclusively be an IT thing as it also reverberates across other sectors of the economy.

AI is not Exclusively an IT Thing

Even before the advent of ChatGPT, AI had already been making rapid progress, and now occupies a more important place in our daily lives as exemplified by chatbots that pop up when you are browsing a website such as UnitedHealth's AI-based virtual assistant, targeted online advertising which forms part of online purchase platforms, as well as engagement-promoting interactions on social networks.

Some of the tasks handled by AI include picture and speech recognition, language processing, decision-making, and problem-solving. These technologies are characterized by their usage in a range of industries as well as their ability to improve productivity. Moreover, far from being restricted to IT, AI is also used, in healthcare, finance, transport, manufacturing, and education. For this matter, it includes the creation of software applications or robotic hardware capable of performing tasks that would typically require human-level intelligence.

Talking figures, according to a study by McKinsey, Generative AI, or the technology that drives ChatGPT, by itself can enable productivity gains of 0.1% to 0.6% yearly till 2040 which will in turn depend on the pace of adoption and the way employees are redeployed across the organization. Singling out healthcare, which constitutes 14.76% of AIO's portfolio as charted below, it should see $150 to $260 billion of AI-led productivity gains.

Similarly, there are gains for other sectors of the economy like Consumer, Industrial, and Financial as well as for Agriculture where Deere is using ML (machine learning) for data analysis purposes, with the ultimate aim of providing farmers with insights on how to optimize crop yields.

As for IT itself, as exemplified by Nvidia and Microsoft, they are the very building blocks for the AI infrastructures with their GPU chips and intelligent clouds respectively. In this respect, the chat-based software developed by OpenAI managed to put the theme of artificial intelligence back at the heart of the social and economic agenda. One of the reasons was because of the simple user interface consisting of entering a question and receiving a single, detailed answer in a large number of knowledge areas, with the system already demonstrating its ability to deliver results in medicine , law , physics, economics, etc.

AIO's Income-Generating Strategy and Risks

As a result of investing in the broader AI theme, the fund managers aim to capitalize on "long-term secular growth opportunities". However, unlike the two other actively managed ETFs I talked about earlier, or the Technology Select Sector SPDR Fund ETF ( XLK ) which passively replicates the performance of an index to provide investors with capital gains and aggregates the dividends of their holdings, Virtus' strategy is geared toward a stable and substantial income stream.

To this end, it uses a multi-asset strategy consisting of holding both equities at 47.23% of the portfolio, and convertible securities constituting 34.23%. These are usually bonds or preferred stocks that can be converted into a different security or a company's common stock.

Another major differentiator compared to funds that specifically provide exposure to the AI theme, like WTAI and BOTZ, is high-yield bonds, which make up 15% of AIO's portfolio. Looking deeper, these consist mostly of non-rated bonds (67%), or those with a rating of BB (16.42%) and B (16%). Now, for risk-averse investors favoring investment-grade fixed income, this may not be the right investment, with the fund also making use of leverage for 16.24% of its total net assets.

Now, with the resilient economy and more analysts expecting a soft landing as of August 21, or no recession despite the higher interest rates, riskier assets like high-yield bonds may not necessarily be volatile.

On the other hand, if you believe that the unprecedented pace (in the last four decades) at which the Federal Reserve has been raising rates since March 2022 may result in increased default risks, possibly next year as a result of companies having to refinance at higher borrowing costs, then it may be better to avoid high yield bonds. In this case, some point to a recession occurring in the Summer of 2024.

Not the Right Time

Thus, for those who are contemplating a new investment with a three or five-year time horizon, AIO may not necessarily be the best way to get exposure to artificial intelligence mainly due to its multi-asset strategy, which, after having worked so well up to now in delivering high-income may suffer in case macros deteriorate in 2024. This should in turn lead to higher risks of defaults in the high-yield space. Now, for investors, this juicy rate of return (10%) comes with higher risks than investment-grade bonds and during a market turmoil, bond prices may get devalued due to credit rating agencies downgrading the company issuing the debt.

On the other hand, AIO's broad AI approach makes sense as the McKinsey report also places the United States together with other developed markets as one of the early adopters of Generative AI. This means that through its equities, specifically chosen by the fund managers due to their AI advantage, the fund should continue to see capital gains unless there is a market crash.

Talking valuations, AIO's P/E of 22.82x is still far below the category average of 27.28x as shown in the table below, which may mean that it trades at a discount. However, its holdings are only about 50% tech as shown above, compared to 96% for XLK and 28% for the SPDR S&P 500 ETF Trust ( SPY ). As such, AIO's P/E of 22.81x approximately equals the average of XLK's, and SPY's multiples of 23x (26.2 + 20.02)/2). This means that at $18, the ETF is fairly valued.

This further reinforces the hold position.

Finally, AIO is a CEF that will terminate on or around October 29, 2031, except if its Board of Trustees chooses to extend its term by up to 18 months.

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