AIO - AIO: Not The AI Exposure You Would Expect

2023-03-30 21:35:50 ET

Summary

• AIO is marketed as an artificial intelligence fund that pays a high yield.
• The fund pays an attractive 10.7% forward yield.
• However, the AIO fund's top holdings do not hold companies typically associated with AI.
• Investors looking for AI exposure should look elsewhere.

The Virtus Artificial Intelligence & Technology Opportunities Fund ( AIO ) is marketed as a high yielding fund that gives investors exposure to the secular growth trend in artificial intelligence.

However, a closer look at the fund's holdings show that it does not hold many companies that are typically associated with AI.

Although it pays an attractive 10.7% forward yield, I think investors looking for AI exposure should look elsewhere.

Fund Overview

The Virtus Artificial Intelligence & Technology Opportunities Fund is a closed-end fund ("CEF") that aims to generate high income from and capital appreciation by focusing on long-term secular growth opportunities. It employs a multi-asset approach with allocations to debt and equity, wherever the risk/reward is attractive.

During normal market conditions, the fund intends to invest at least 80% of its net assets in securities issued by artificial intelligence companies and in other companies that stand to benefit from artificial intelligence and other technologies.

The AIO fund may use leverage to enhance returns. As of March 29, 2023, the fund had $130 million in debt against $785 million in gross assets for 16.6% effective leverage. AIO charges a 2.04% net expense ratio (Figure 1).

Artificial Intelligence - A Fad Or The Next Secular Growth Opportunity?

Since the beginning of the year, much ink has been spilled about 'artificial intelligence' ("AI") and the coming automation revolution. In fact, some recent news articles suggest as many as 300 million jobs could be affected globally. So is AI just the latest fad or a new secular growth trend?

My personal belief is that it has the markings of both a fad and a secular growth trend. The development of AI technologies has actually been underway for decades. Only recently have advances in computer processing power and AI algorithms brought it to the forefront of our awareness.

Nowadays, the amount of data (such as online text, chats, video, and other media) available to train AI algorithms is increasing at an exponential rate and new AI models are constantly being developed. These AI models are able to leverage developments in computing power, chiefly the development of advanced processors and cloud computing technologies, which have made the mass deployment of these AI models feasible.

However, there is an element of faddism to the public's infatuation with all things AI at the moment. For example, NVIDIA Corporation ( NVDA ), one of the leading graphical processor unit ("GPU") designers and manufacturers (GPUs are crucial to process information and train AI algorithms), has seen its stock price almost double YTD on optimism of its AI business (Figure 2).

While AI applications certainly can boost NVDA's revenue and earnings potential, it is a little hard to fathom a $300 billion market cap company almost doubling in a span of 3 months. In fact, after the recent surge, NVDA is now the 6th largest publicly traded company in the world by market cap (Figure 3).

While a bullish case can be made on NVDA's stock, it does have very big shoes to fill in order to 'grow into' its valuation.

My personal belief is that AI is a secular growth trend for the next few decades that will revolutionize entire industries and how we conduct business. However, like how the Internet revolutionized business and spawned entire new industries, there will inevitably be winners and losers (anyone old enough to remember pets.com?). The key is to take a basket approach in AI investments, since early winners may not stay as winners with constant change and disruption (see the fall of Yahoo ).

Portfolio Holdings

Coming back to the AIO fund, figure 4 shows the fund's asset allocation as of December 31, 2022. The fund has 44.6% of assets invested in convertible securities, 36.7% invested in common equities and 15.4% invested in high yield bonds.

Sector-wise, the AIO fund's biggest weighting is in Information Technology, at 40.0%. This is well expected, as AI is predominantly a technology-focused theme. AIO also has 20.5% invested in Health Care and 14.9% invested in Consumer Discretionary (Figure 5).

Are These The Top AI Holdings?

I asked ChatGPT , OpenAI's generative AI chatbot, to name some of the leading companies involved in the AI ecosystem. Figure 6 shows the chatbot's answer.

Interestingly, with the exception of Microsoft ( MSFT ), which the AIO fund holds a mere 1.7% position in, none of the other top companies mentioned by ChatGPT makes it into AIO's top holdings (Figure 7).

While the AIO fund is marketed as focused on AI related companies, its security selection leaves much to be desired.

Distribution & Yield

AIO pays an attractive monthly distribution of $0.15 / share or an annualized yield of 10.7%. On NAV, AIO is yielding 9.4%.

Investors should note that AIO's distribution has been funded from a combination of net investment income ("NII"), realized gains, and return of capital ("ROC") (Figure 8).

This is to be expected, as high growth stocks in sectors like Information Technology tend to pay little in terms of dividends. A hybrid strategy like AIO's, which involve both high yielding investments and high growth stocks, should see significant use of realized gains and ROC to fund its distribution.

The key to assess the sustainability of AIO's distribution is to compare the distribution yield against the fund's long-term returns. If the fund earnings more than it pays out on average, then the distribution is sustainable. In AIO's case, the fund pays a 9.4% of NAV distribution and has a 3Yr average annual return of 11.6%, so its yield should be sustainable.

Returns

Figure 9 shows the AIO fund's historical returns to February 28, 2023. Overall, the AIO fund has delivered mixed returns, with a -21.9% loss in 2022, but a decent 11.6% average annual return measured on a 3-year time horizon.

Importantly, with AI being all the rage so far in 2023, the AIO fund has only delivered a modest 6.3% return to March 29, 2023. This pales in comparison to some other leading AI investments such as the Global X Robotics & Artificial Intelligence Thematic ETF ( BOTZ ), the First Trust Nasdaq Artificial Intelligence and Robotics ETF ( ROBT ), or individual securities like NVDA, MSFT, or Alphabet Inc. (GOOG) ( GOOGL ) (Figure 10).

I believe the problem is AIO's portfolio, while marketed as being focused on AI investments, actually have very little in terms of AI exposure. UnitedHealth Group ( UNH ), McDonald's ( MCD ), and Schlumberger ( SLB ), while fantastic companies in their own right, are not what comes to mind when investors think about leading companies in AI technologies or applications.

Conclusion

The AIO fund is marketed as a high yielding fund that invests up to 80% of its assets in the artificial intelligence secular growth trend. However, a closer look at the fund's holdings show that it does not hold many companies that are typically associated with AI. As a high yielding fund, AIO may be attractive with a 10.7% forward yield. However, if investors are looking for AI exposure, they may need to look elsewhere.

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