FLAU - IAF: 10% Yield From A Leading Australian Equities CEF

Summary

• IAF invests across Australian stocks.
• The fund has managed to outperform its benchmark historically while gaining momentum in recent months.
• IAF is well-positioned to continue delivering positive returns including through a compelling 10% distribution yield.

The Aberdeen Australia Equity Fund ( IAF ) invests in Australian companies capturing both country-specific economic trends along with high-level macro themes. This is a closed-end fund that has impressively outperformed its benchmark and comparable ETFs historically while gaining momentum in recent months.

What we like about IAF is that it offers a 10% yield through its managed quarterly distribution making it a good income vehicle in this unique market segment. Despite a volatile 2022, Australian stocks have entered the new year supported by new tailwinds across rebounding commodity prices, a strengthening local currency, and firming sentiment. We are bullish and expect the rally to continue.

What is the IAF Fund?

A key point about IAF is that the fund is actively managed meaning it's not intended to follow any particular index with each holding at the discretion of the management team. Aberdeen is a recognized institutional money manager with IAF tracing its inception date back to 1985. The objective is long-term capital appreciation and current income, with the distribution intended to be covered by the underlying portfolio income and realized gains while a return of capital has been used at times over the past decade.

The fund also utilizes a small amount of leverage, last reported at approximately 5% of the total $135 million in assets under management. A total expense ratio of 1.6% is inclusive of the 0.95% management fee. While elevated relative to passively managed funds, the fund fee is otherwise comparable to similar equity CEFs.

In terms of the strategy, IAF is a straightforward long-only equity fund and does not utilize derivatives. Large-cap and high-profile Australian companies like BHP Group Ltd. ( BHP ), Rio Tinto ( RIO ), and several of the country's major banks are among the top holdings. The Financials sector represents 28% of the total weighting, followed by Materials at 25%, and the Health Care sector at 14%.

It's a good range of companies as a cross-section of the Australian stock market. On this point, there are not many surprises in the portfolio in terms of names relative to country indexes. That being said, when we start looking at the performance of IAF, the return spread will largely be explained by the difference in weightings of the underlying stocks.

For example, investors have the option to simply buy and hold the iShares MSCI Australia ETF ( EWA ) which has a similar exposure to IAF. There is also the separate Franklin FTSE Australia ETF ( FLAU ) which tracks the FTSE Australia index. We're simply using these funds as a reference point. What we find is that the Aberdeen fund ends up overweighting certain stocks and underweight others, which is a reflection of the portfolio manager's market views and perception of relative value.

For example, IAF's 10% weighting in the mining giant BHP compares to a 14% holding in EWA . On the other hand, the IAF allocation towards Rio Tinto at 3.8% is above 2.6% in the index tracking EWA ETF. What we can say is that IAF is a bit less concentrated with the top-10 holdings representing 56% of the fund, compared to 61% in EWA. This dynamic implies that the Aberdeen fund adds greater importance to mid- and small-cap stocks down the portfolio which contributes to its return profile.

IAF is a Good Performer

With data going back to 2017 when FLAU began trading, IAF has managed to deliver a 46% total return at NAV which is above the 40% from FLAU and 35% from EWA. One takeaway from the chart below is that IAF appears to have been more volatile since the 2020 pandemic crash, but also outperforms to the upside during periods of positive momentum.

On the other hand, IAF may also underperform to the downside based on its small use of leverage and CEF structure. This suspicion is confirmed by the -2.9% loss over the past year from IAF, while EWA and FLAU managed a 3% return. Going back, the weakness in 2022 considers the macro headwinds between stubbornly high inflation and rising interest rates, with a more uncertain global growth outlook.

Fast forward, the setup over the last few months has been defined by the improving momentum with IAF climbing 25% since its low in mid-October. As we will highlight below, a major shift over this period has been the strong performance of the Australian Dollar, reversing the trend from the first half of last year.

Sentiment towards the Asia-Pac region has improved following signs China was easing its Covid restrictions to stabilize the economy. This is important because Australia is a major trading partner in the region and the rebound in trade activity has helped drive a recovery in investment demand. A rally in iron ore and copper prices explains some of the momentum in materials sector names like BHP and RIO, while most other stocks across the underlying portfolio are also up over the past month.

Australia Macro Update

According to the Reserve Bank of Australia, the nation's central bank, 2022 GDP growth is expected in a range of around 4% pending final figures. The context here is that the country benefited from the post-pandemic recovery , which largely lagged the timetable of other countries considering its stricter Covid restrictions between 2020 and 2021. The strength was driven by services, with tourism as an example of an area that bounced back but remains below pre-pandemic levels.

On the other hand, the expectation is for the pace to normalize into 2023 towards a softer rate of around 1.5%. This would be based on tighter financial conditions considering the recent rate hike. This narrative is confirmed in the last monetary policy statement .

The Australian economy is continuing to grow solidly. Economic growth is expected to moderate over the year ahead as the global economy slows, the bounce-back in spending on services runs its course, and growth in household consumption slows due to tighter financial conditions. The Bank’s central forecast is for growth of around 1½ per cent in 2023 and 2024.

In December, the Reserve Bank increased the policy rate by 25 basis points to 3.1%. This is in an attempt to bring down inflation which climbed to a cycle high above 7%. Favorably, the expectation is that easing global supply chain pressures reduce that headline towards a 2-3% target by 2024, next year.

As it relates to equity investors and the IAF fund, possibly the most positive development has been the rally in the Australian Dollar, up 12% since its low against the U.S. Dollar in early October. The trend follows the broader move in the U.S. Dollar over the period, weakening against a basket of global currencies amid easing inflationary pressures and the pullback in bond yields pulled back based on the implications for Fed policy.

There is a sense of relative stability in the Australian economy with the door open for macro conditions to evolve better than expected going forward. We mentioned the connection with China, the country's largest trade partner. China reported resilient GDP growth in 2022, despite its lingering Covid disruptions.

The expectation is that stronger growth going forward may help support activity in the region along with adding a boost to commodity prices. By this measure, the Australian economy and the underlying companies in IAF are well-positioned to benefit. Notably, copper prices have rallied alongside the Australian Dollar as a positive signal for broader economic conditions.

What's Next For IAF?

Overall, our take is that IAF is a high-quality fund with several advantages for investors compared to the country ETFs in the category. We like the wide discount to NAV currently listed at 10% while the 10% distribution yield adds a compelling income component.

In our opinion, Australian stocks are well-positioned to continue delivering positive returns. From the IAF price chart, it's encouraging that shares have broken above the long-running trendline since the first half of last year.

The next leg higher will largely depend on how macro conditions evolve. We want to see the Australian Dollar continue climbing while economic indicators like inflationary trends in the country and steps in monetary policy will be key monitoring points.

On the downside, the risk here would be more concerning the deterioration of the macro environment. A re-acceleration of inflationary trends or sharply lower trade activity would undermine the bullish thesis. In the near term, as long as the fund holds the $4.50 level, the bulls remain in control.

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