AIO Fund: Its Differences Make A Difference (NYSE:AIO)

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on December 29th, 2022.

Virtus Artificial Intelligence & Technology Opportunities Fund (NYSE:AIO) has found itself outperforming the rest of its ‘peers.’ In the chart below, we compare AIO to Neuberger Berman Next Generation Connectivity Fund (NBXG), BlackRock Science and Technology Trust I and II (BST) (BSTZ), and Columbia Seligman Premium Technology Growth Fund (STK). We are looking at both the total share price and NAV returns on a YTD basis.

Since we last covered the fund earlier in June of this year, it has done relatively well too. The S&P 500 Index isn’t an appropriate benchmark, but it can give us some context.

There seems to be a pretty simple reason for this; it isn’t as much of a tech fund as its name would imply. They invest in a meaningful allocation of large-cap names such as UnitedHealth Group (UNH), Deere & Co. (DE), and Elevance Health (ELV). These are their top three holdings.

These are types of names that don’t necessarily come up when thinking about the technology sector. I think that’s okay, too. There is nothing wrong with a fund that takes a bit of a different approach. Clearly, in 2022, staying in more conservative names outside of tech worked out the best. However, investors should be aware of this. They also take a hybrid approach in deploying capital to different security types such as convertibles, equity and high-yield bonds – the other names listed above stick with mostly equity investments to a large degree.

At this time, AIO is trading at a deep discount. A touch wider of a discount than when we last covered the fund. If you have a longer-term time horizon, it could be worth exploring. In general, it seems that tech could continue to struggle in 2023 as the Fed remains in hike mode.

The Basics

• 1-Year Z-score: -1.27
• Discount: 15.56%
• Distribution Yield: 11.28%
• Expense Ratio: 1.53%
• Leverage: 15.84%
• Managed Assets: $820.74 million
• Structure: Term (12th year, expected October 29th, 2031)

AIO 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.”

With “…dynamically allocating to attractive segments of a company’s debt and equity in order to offer an attractive risk/reward profile.” That leaves AIO flexible to invest across assets in this market segment. That is one of the main reasons that sets this fund apart from its CEF tech-focused peers. As we highlighted above, it isn’t just in theory, but in practice, the performance has been different.

One of the big news items in our last update was that Voya would become the subadvisor after AllianzGI was barred from operating funds in the U.S. This meant, instead of the managers working for AllianzGI, Voya now signs their paychecks. There was actually no change in the funds in a fundamental way. It was announced in November that AIO shareholders approved the new subadvisory agreement.

The fund utilizes a moderate amount of leverage, which increases downside risk and can also boost the upside potential. Having significant weightings to the volatile tech sector, it would seem appropriate to employ leverage more conservatively.

Their borrowings are tied to a floating rate; the last weighted average interest rate came to 1.41% at the end of July 31st, 2022. However, on the final day of the semi-annual reporting period, the interest rate was 2.67%. That highlights how much costs for borrowing have gone up as the Fed raised rates. Since rates have only risen further from there, the costs for leverage have only increased even further.

Performance – Attractive Discount

We saw above how AIO performed on a YTD basis relative to some of its closest peers. They rode the giant tech wave higher, but what is helping the fund this year made it underperform through the 2020 and 2021 tech surges. I’ve excluded NBXG here because it came to market in mid-2021.

STK had similarly lagged during the raging rally for growth through those years but still came out on top amongst these four CEFs. It has also avoided the significant drops we’ve seen in BST, particularly BSTZ. BSTZ is the techiest of these tech funds, with allocations to smaller and private positions. It paid off in a big way but has fallen spectacularly through 2022.

The fund hasn’t been around too long, with inception near the end of 2019. So, the annualized returns don’t give us much of a track record at this point.

Past performance is fun to look at, but it doesn’t tell us about the future. I think the fund’s most interesting metric is the fund’s deep discount at this time. With a limited track record, we can’t really gauge what its longer-term discount might end up being. At this point, it is trading at almost the widest discount it has ever been at – excluding the COVID spike.

As a term fund, though, we know that eventually, it can be realized. It isn’t anticipated to be liquidated until 2031, meaning we have a considerable amount of time before that becomes a more important factor.

Distribution – Lack Of Capital Gains

AIO has been able to grow its distribution and pay out a couple of quite large year-end specials in its short history.

However, the lack of capital gains is something to watch. It isn’t uncommon for equity funds to rely on capital gains to fund their distributions. For AIO, though, it is something they rely on entirely.

Similar to the rest of these more tech-oriented funds. They generally have a net investment income loss, meaning that after expenses, there is no income left over for shareholders. They have to earn enough capital gains to pay out the distribution and to pay for the expenses of the fund.

We can see in the latest semi-annual report they didn’t realize enough gains that came close to “covering” the distribution. With a bear market, it becomes harder and harder to come by capital gains, too. They don’t utilize any options writing in this fund, either, that some of the peers can fall back on for some capital gains even in a down or flat market.

Therefore, while the distribution yield of 11.28% is attractive, it might be hard for the fund to maintain the 9.52% distribution rate on the NAV. I wouldn’t be surprised if the fund cut its distribution to avoid eroding too much capital.

The fund’s distribution last year was classified mostly as ordinary income dividends for tax purposes. Only a relatively small amount was considered qualified. The rest was long-term capital gain distributions. Last year was the massive year-end special, so the total distributions paid look quite impressive.

I generally ignore the section 19a notices from CEFs, but in this case, we see some return of capital. Given this year’s results, it isn’t surprising to see some of this ROC in the official tax classifications.

AIO’s Portfolio

The largest allocation for AIO is to convertible securities. These were quite popular in the last couple of years when interest rates were 0%. Several companies could issue convertible debt with minimal to zero coupons.

The upside would primarily come from an appreciation that could be realized. That worked out great when things were rising, but all these have been trending lower with the common stock share prices that have also been collapsing in many tech names.

The good news here is that there is eventually a floor with convertibles. As long as the company that issued them doesn’t go bust, par should be repaid to the holders. On the other hand, it could also mean holding a security for several years with minimal to no returns.

As mentioned at the open, they aren’t your typical tech CEF. They carry a significant weight to the tech sector, but healthcare, consumer discretionary, industrial, and communication services also make up fairly significant allocations.

We listed their three top positions above. However, there are some more quite interesting names that you might not expect in an AI and tech fund. Exposure to T-Mobile’s (TMUS) Mandatory Exchangeable Trust is one of those names.

More specifically, seeing McDonald’s (MCD) here could be quite a shock. However, it can make more sense when considering the many improvements that AI and robots can make in fast-food restaurants. That’s essentially the reasoning behind UNH, DE, and ELV. While they aren’t your usual AI-related names, there are a lot of advancements in AI that could provide more efficiencies.

With tech weights that high, some tech names will inevitably make their way into their top ten.

Conclusion

AIO is a unique tech fund with a broad portfolio, with much more flexibility than its tech-related peer CEFs. That has helped the fund from dropping as far as peers have. However, it also meant lagging results when times were much better for tech, too. The fund’s large discount could make it a much more interesting name to consider at this time.