AZNCF - AIO: Some AI Exposure But Not Exactly An AI Play

2023-11-27 15:07:58 ET

Summary

• Virtus Artificial Intelligence & Technology Opportunities Fund (AIO) has added more AI and tech companies to its portfolio.
• However, the fund's performance has been relatively lackluster compared to its tech-oriented peers, as its differentiated approach has been a drag on results.
• AIO offers an attractive distribution rate of 11.02%, but the capital gains to fund the payout have been lacking recently.

Written by Nick Ackerman, co-produced by Stanford Chemist.

It has been some time since we gave Virtus Artificial Intelligence & Technology Opportunities Fund ( AIO ) a look. At the time, their positioning favored some larger cap companies that one probably wouldn't have expected for a tech fund. Those included names such as UnitedHealth Group ( UNH ) and Deere ( DE ) as its largest positions.

However, since our earlier coverage at the start of this year, the fund has seemingly started to position more toward an AI focus, with mostly tech companies now making up the largest positions of the fund, including NVIDIA ( NVDA ) as its third largest. That said, the managers have a lot of flexibility in this fund. There are still plenty of holdings that aren't tech/AI related.

The Basics

• 1-Year Z-score: -0.73
• Discount: -12.99%
• Distribution Yield: 11.02%
• Expense Ratio: 1.58%
• Leverage: 17.38%
• Managed Assets: $748.04 million
• Structure: Term (anticipated liquidation date on October 29, 2031)

AIO is focused on generating "a stable income stream and growth of capital by focusing on one of the most significant long-term secular growth opportunities in markets today." They will do this by investing "in a growing universe of opportunities across a broad spectrum of technologies and sectors embracing the disruptive power of artificial intelligence and other new technologies."

The fund employs a modest amount of leverage, though any leverage means that both the upside moves and the downside moves will be larger. It also means they are having to deal with higher borrowing costs that have pushed up the total expense ratio to 2.79%.

Performance - Positioning Matters

Tech has been soaring this year, with the Magnificent 7 stocks making up most of the gains for the overall market; AIO's performance, on the other hand, has been relatively muted. So it would seem despite that strength and holding several of the Magnificent 7 names in its top ten, it hasn't been able to gain traction, which would understandably be disappointing for current shareholders.

For some context, several of the fund's tech-oriented peers have been seeing a recovery as we are heading through 2023. Of course, tech took a huge hit in 2022, so some of this was rebounding, but suffice it to say tech, as highlighted by the Technology Select Sector SPDR ( XLK ), has been performing quite well.

Several of the tech-oriented peers, such as BlackRock Science and Technology Trust ( BST ) and Columbia Seligman Premium Technology Growth Fund ( STK ), clearly benefited from their tech weighting. Even Neuberger Berman Next Generation Connectivity Fund ( NBXG ) saw respectable results this year, and that fund is also a bit different, similar to AIO, in that it isn't only tech-focused. Around 50% of AIO is allocated to the tech sector, and NBXG is around 55%.

Before November, the total NAV return for AIO was basically flat.

It is worth pointing out that since AIO does take a different approach, and it was holding several unusual 'AI' names, 2022's results were better, at least relatively speaking.

That being said, to explain some of this weak performance through 2023, it does go back to the asset allocation this fund takes. This isn't just an equity fund; it also carries convertible securities and high-yield bonds. The fund is leveraged, which sets it apart even further when compared to these tech-oriented CEFs.

AIO is also trading at a fairly attractive discount at this time, as it has been trading near the lower end of its range since it launched. Of course, that excludes the Covid spike that saw many discounts widen massively but quite briefly.

Distribution - Tempting But Elevated

The fund has been able to raise its distribution a couple of times since it launched at the end of 2019, and it paid out a couple of year-end specials. It also currently pays a distribution rate of 11.02%. That's the good news.

The bad news is that this is quite elevated, and given the relatively weaker performance this year and last, the distribution rate is starting to inch up near the 10% mark on an NAV basis. That doesn't mean that the fund will cut its distribution, but for a fund that holds a heavy weighting to equities, that's often at least a yellow flag to consider.

Despite having fixed-income exposure, this fund shares the common feature of those other tech funds in that it doesn't have any positive net investment income. That means that after the expenses are deducted from the dividends and interest received by the fund, there is no income being generated by the fund left over for shareholders.

This isn't that uncommon for tech-oriented funds, but it is for funds that have fixed-income exposure. As the fund will require capital gains to fund its entire distribution, we would really want to see a recovery for the fund before getting too comfortable with its payout. With inflation continuing to cool, according to the latest CPI report, that's definitely encouraging.

Worth noting, though, that despite not having income left for shareholders, for tax purposes, a portion of the distribution has been ordinary income. This was significant in 2022, but it did moderate in 2023. A large portion of this came from short-term capital gains in 2022. So clearly, tax efficiency is not on the minds of the managers. The fund had also been utilizing return of capital distributions in fiscal 2023, and since the NAV had declined during that time, it would have been considered destructive ROC.

AIO's Portfolio

AIO continues to have its largest weighting to common equity securities, but they carry a meaningful weight to convertible securities and high-yield bonds. The convertible securities can offer some yield but also allow for potential upside.

In looking more closely at AIO's portfolio, we get a good look at how the top ten have changed year-over-year. This is because our last update provided the top ten holdings as of the end of September 2022, and the most recent top ten provided by Virtus is for the end of September 2023.

Here's a look at the top ten listed in our prior update:

Here is the top ten as of the latest information available:

NVDA, being somewhat of the poster child for AI these days, is probably something that should have been higher on their priority list in the first place. At the end of their last fiscal year, January 31, 2023 , NVDA was not a holding. It didn't show up in the fund until July 31, 2023, in their semi-annual report . NVDA was listed in their N-PORT for the period ended April 28, 2023. At that time, they held 22,750 shares, which rose to 32,865 by their semi-annual report. This further increased to 34,950 as of the end of September .

There are still a couple of holdings that might be a bit more unusual for a tech/AI fund: AstraZeneca ( AZN ) and Hilton Worldwide Holdings ( HLT ) would be two that stand out. Those are the types of names that you might not expect to be in this type of fund.

Besides NVDA, Microsoft ( MSFT ) saw its weighting increase in the fund. Flex Ltd ( FLEX ) also now comes in as the largest holding. FLEX is a tech company located in Singapore that provides supply chain and manufacturing solutions.

With the portfolio shift toward more tech positions in their top holdings, it's certainly something to consider that they had missed quite the run-up before they started adding. Specifically, adding further to NVDA as it kept going higher could turn out to be a great move or look pretty bad if the hype and growth start to sour. The AI bulls would almost certainly argue that the AI boom is merely getting started, but only time will tell.

The tech weighting for the fund overall has also increased since last year. That said, it was already a significant weighting for the fund being well overweight relative to the other sector exposure.

Conclusion

AIO is an interesting fund, but it isn't quite the AI fund that some investors might mistake it for by the name alone. Instead, they take a flexible approach and make any company fit into this bucket. They also take a flexible approach in terms of asset allocation, which has seemed to hurt the fund as well, even as tech and specifically AI have been booming. That said, they seemed to have tilted their portfolio to a more AI-centric tilt through 2023, but there are still a lot of other non-AI and tech-related holdings in this fund. Therefore, going in with the expectation that it is an AI play probably isn't the right mindset. It could still be a decent fund trading at a fairly attractive discount when going in with the right expectations.

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