Fund Spotlight: AllianzGI Artificial Intelligence & Technology Opportunities Fund

Summary

• AIO is a newer fund launched last October dedicated to the artificial intelligence space. This is mostly marketing pushing a new fund in a hot new area.
• The fund is 50% in technology stocks that Allianz managers believe will benefit from the AI movement. The rest of the portfolio is in convertibles.
• We compare the funds to its peers like STK, BST, and BSTZ and see that it's good at keeping up with half of the portfolio in convertibles.
• The current discount is appealing as at -11.5% and we think fair value may be a few points tighter.
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(This report was published to members of Yield Hunting on May 15. All data is from that date unless otherwise stated.)

AllianzGI Artificial Intelligence & Technology Opportunities Fund (NYSE:AIO)

This is a relatively new fund - now seven months old - with Allianz pushing the marketing of AI. The fund, which came to market on Halloween 2019 IPOd at a $20.00 NAV. The price was also launched at $20 with Allianz eating those offering costs, a trend that's increasingly being used to make CEF IPOs more palatable. We are rarely seeing the old strategy of offering new CEFs at a premium to NAV.

In addition, another trend we are seeing is the shift toward new funds having a term structure. This is a fund that liquidates at a certain date (but not certain price) in the future at NAV. This is a benefit to the shareholder since it tends to tether the price closer to the NAV, especially as the liquidation approaches. I would place little value on this at this point in time. For one, there has been a trend toward funds switching at the last moment to perpetual trusts eliminating the liquidation provision. Second, the offering documents state that they extend by a year without shareholder approval for up to one year and then again for another six months.

The fund does not typically use leverage though they have the ability to through the issuance of preferred shares, bank lines, or other borrowing like reverse repos. The portfolio is mostly made up of technology stocks and convertible securities. We detail more below.

As the name suggests, the marketing wizards at Allianz are pushing a new tech fund with a particular focus on artificial intelligence. The fund can invest across the capital structure (meaning stocks, bonds and everything in between) and in a broad range of industries. The investment strategy is to focus on companies that they believe will "benefit from the evolution and disruptive power of artificial intelligence and other new technologies."

The term artificial intelligence ("AI") can mean a lot of different things to different people. In this case, the fund considers it to mean the use of systems or other technologies able to either perform tasks that normally involve human intelligence, such as visual perception, speech recognition, and decision making. From the prospectus:

The portfolio managers believe that innovative companies in any sector that are able to leverage artificial intelligence or other new technologies to transform their businesses will be well positioned to gain market share, outperform industry peers and create superior shareholder value over time. In addition, the portfolio managers believe that artificial intelligence and other new technologies can be used to disrupt industries through (i) the deployment of new artificial intelligence infrastructure and secondary technologies as building blocks to enable new capabilities, (ii) the development of new artificial intelligence software applications to make smarter insights and decisions, (iii) the adoption of artificial intelligence or other new technologies in key business processes to enhance operations and/or develop new products and services that drive a competitive advantage and (iv) other key trends and developments. Under normal market conditions, the Fund will seek to achieve its investment objective by investing in a combination of convertible securities, equity securities, and debt and other income-producing instruments.

Fund Characteristics

Total assets: $702M

Leverage: 0% (it can employ it but will likely not do so often)

Distribution: $0.1083 (monthly)

Distribution rate: 7.13%

Discount: -11.33%

Number of holdings: 104

Term fund: Yes.

Liquidation date: October 29, 2031

The Portfolio

As noted above, the fund is about half invested in technology stocks and the remainder in convertible securities. Most investors understand tech stocks but convertibles are foreign to most. Convertibles are a hybrid security that combine some characteristics of a stock and some of a bond, the goal being to enhance returns to their fixed income allocation without the risk of equities. The advantage being that you can have some or all of the upside of stocks while reducing volatility. Some studies have shown that convertibles have about 90% of the upside of stocks but less than 60% of the downside for an attractive risk-reward profile. Convertibles also are higher ranking in the capital structure than stocks in the event of bankruptcy or liquidation.

(Source: Invesco)

Investors can convert their shares into the company's stock if it hits a certain price, known as the conversion price. If the price of the stock falls, the convertible acts more like a bond (though converts pay lower coupons). That's the benefit of having the upside.

The market for convertibles is fairly small with just $70-$90B of new issuance each year. Most convertibles come from the technology sector already as they are a means for raising capital (as they are typically losing money early on) and reward investors with the upside in their share price.

For AIO, the fund is split between common shares and convertibles.

The top holdings account for nearly one fifth of the fund's assets, though the fund has over 100 positions - most being really small and inconsequential to performance. There are some household names on the list with Microsoft (MSFT) being at the top of the list. Obviously, their software is thought to be the backbone of a lot of new AI technology. The second name on the list is Equinix (EQIX), a large data center REIT. Third was UnitedHealth Group (UNH), a name that's not typically associated with AI.

The portfolio is slightly leveraged currently likely because of the sell off in tech stocks (and stocks in general). The NAV of AIO fell almost 27% peak-to-trough.

Data by YCharts

After falling ~27%, the NAV has recovered nicely by over 30.2%- but still is NOT back to the prior peaks.

Data by YCharts

Remember, the above two charts are of net asset value "NAV." But as an investor in the fund, you don't pay NAV, you pay price and with a fixed number of shares the price can deviate significantly. We can see that the price has lagged the NAV since the start of the year. The discount has widened by nearly 8% over that time with most of that widening occurring in the last couple of months.

Data by YCharts

We can see that in a chart of the discount to NAV since the inception in October. While the discount was much wider in March when everything blew out, the current discount is compelling.

Data by YCharts

The discount is more compelling compared to other funds that are similar. I compared it to Blackrock Science and Tech (BST), Blackrock Science and Tech II (BSTZ), and Columbia Seligman Tech (STK) with AIO. AIO is trading at the widest level- though it is newer without the same length in history. STK has improved its valuation significantly since the rebound in early April. BSTZ, a newer fund as well, is widening its discount along side with AIO.

Data by YCharts

Distribution

Most investors in the CEF space are looking for yield, even from their equity investments. A 7%-plus yield from a technology stock portfolio is obviously not earned. The distribution is immaterial at that point and can be set at whatever level they wish. With that kind of yield the portfolio is paying out some gains and in down months/years capital.

The distribution is $0.1083 per month payable on the first. The shares often go ex-distribution around 10th of the month.

The fund pays a relatively higher yield compared to the other tech funds except for STK:

BST: 5.80%

BSTZ: 5.88%

STK: 8.61%

AIO: 7.13%

Valuation

I really like the valuation here as the fund gives you a nice discount to what I think is fairly value based on where the other funds trade. The nearly -12% discount is likely a result of the lack of trading history. The discount has slowly widened out to the current levels.

From a performance perspective, the fund is doing its job from inception. Despite having nearly half of the portfolio in convertibles, it's keeping up with the other 100% tech-focused equity CEFs.

Data by YCharts

I did compare AIO to XLK, the SPDR Select Technology Sector ETF (XLK), and you can see how much better XLK has done since the inception of AIO. Again, this likely due somewhat to the convertible sleeve. That could partly be a result of AIO having a lot of smaller stocks in it and XLK being heavily weighted into tech mega caps. There's also some sequence of returns risk issues at play here. When the fund is down and you pay a cash distribution, you are essentially selling down. Remember, AIO is not earning that distribution through accrued income of bond holdings. Instead, it's primarily paying out gains. When the fund was down 27% and it has to pay a distribution, that's capital no longer in the fund for the rebound.

Data by YCharts

A better approach would be to see how much downside protection you get from the convertibles sleeve. The below chart shows the peak-to-trough NAV decline of the fund compared to XLK. From this perspective, the convertibles didn't provide much downside protection.

Data by YCharts

Concluding Thoughts and My Two Cents

AIO is an interesting new fund that's playing on the strength of the US technology sector. These stocks have performed exceptionally well and appear to be insulated from the COVID-related shutdown of the economy.

The fund is really nothing special and is typical of the asset management industry. If there's a "hot" theme out there, and AI is definitely one of those hot themes, they tend to launch a bunch of ETFs and OEFs covering it in order to attract AUM. The ARK Innovation ETFs are a good example of that. But buying highly-concentrated and higher risk positions and stuffing them in a fund is really not that beneficial for investors - especially the typical CEF investor hunting for yield.

As the last chart above showed, you could mimic this fund by investing in XLK, the SPDR Tech Sector ETF, and selling a few shares off each month to synthetically recreate your income. But it's really six in one, half dozen to the other.

The only real benefits of a fund like this is 1) being able to juice your return by buying at a discount and riding the wave to mean reversion. On that basis, the discount does look a bit wide here and likely to close in a few points. 2) the convertible portfolio is a nice way to reduce volatility though it remains to be seen if that actually is the case.

Something to watch but for now I'll be looking elsewhere.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.