AIVL: Valuation, Growth Weigh On Rating

WisdomTree U.S. Al Enhanced Value Fund ETF (NYSEARCA:AIVL) is an actively managed investment vehicle with artificial intelligence-backed value-centered strategy, which is, according to its website, is based on the model developed by Voya Investment Management. The fund pursues both "income and capital appreciation." For more details on the strategy, I recommend reading the prospectus.

The previous time I covered AIVL was in April 2022 when I concluded that it was only a Hold owing to the relatively uncomfortable multiples its holdings were trading at, which I uncovered using the Seeking Alpha Quant Valuation data. I also emphasized that AIVL saw a profound strategy change in January 2022, with the WisdomTree U.S. Dividend ex-Financials Index abandoned and its name changed, hence, its returns from 2006 to that moment were of no relevance. At this juncture, AIVL has fifteen full months with the new active strategy in place, so it would certainly be interesting to analyze whether its AI-backed value methodology was potent enough to deliver attractive returns during the bear market.

Why does AIVL not deserve a rating upgrade?

In my view, there is no significant reason to upgrade AIVL to a Buy today. Let me address the key considerations impacting my decision below. In short, my skepticism is based on its questionable performance, imperfect valuation, and lackluster growth.

Performance

In my previous article, I arrived at a conclusion that it was questionable whether the fund was "perfectly positioned for a prolonged capital rotation amid higher interest rates" owing to its exposure to richly valued stocks (which, on a side note, contradicted its value-oriented strategy). Since then, AIVL has failed to deliver performance stronger than the S&P 500 index.

Nevertheless, it still should be noted that AIVL beat the iShares Core S&P 500 ETF (IVV) during the February 2022 - April 2023 period, also with a lower standard deviation. In addition, according to page 16 of the prospectus, the fund is benchmarked against the Russell 1000 Value index, so I believe it would be pertinent to compare its returns to the results of the iShares Russell 1000 Value ETF (IWD). And during the same period, IWD slightly outperformed its AI-reinforced counterpart, even though both were in the red. An important remark here is that IWD comes with an expense ratio of 18 bps, which is 20 bps lower compared to AIVL.

Created by the author using data from Portfolio Visualizer

Overall, I would not say that the fund demonstrated a uniquely strong performance, and thus do not see a justification strong enough for a bullish thesis, at least for now.

AIVL remains a suboptimal choice for value investors

In my opinion, investors who are on the lookout for value ETFs to immunize their portfolios against the ripple effects of a potential recession, which could meaningfully decrease the anticipated growth premia, and find AIVL's AI-guided strategy appealing should carefully consider a few of its valuation disadvantages.

1. Even though AIVL has seen a thorough recalibration since my previous note, with removed stocks accounting for about 51% of its holdings as of end-April 2022 and newcomers now accounting for 38% of its portfolio of 101 companies, its value characteristics are still imperfect. It is true that the weighted-average market capitalization retreated from around $75.9 billion to approximately $60.5 billion (as May 5), yet the share of stocks trading at a discount to their respective sectors and historical averages (as measured by the Quant Valuation grade) has remained almost unchanged, standing at ~20%. At the same time, those trading at a premium (with a D+ Valuation grade and worse) now account for ~56% vs. 48.4% previously.
2. Most stocks from the cohort of the relatively overvalued are industrials (~14.6% of the net assets) and healthcare (~13.6%). More specifically, I was surprised by the fact that AIVL has exposure to only three relatively modestly valued industrial names, 3M (MMM), MDU Resources (MDU), and Johnson Controls International (JCI); the rest are priced at a premium. One of the factors also worth taking into account is that my calculations show that the median Enterprise Value/EBITDA ratio for industrial companies in the AIVL basket is 14.1x, while the sector median is 11.45x as of writing this article. Investors should answer by themselves whether they are content with exposure to richly priced cyclical players while the economy is most likely heading into a recession, even assuming these stocks have solid quality (all have no less than B- Profitability grade except for MDU and Woodward (WWD) that are C- and C rated) and adequate leverage (with median Total debt/EBITDA at 2.4x, as per my analysis).
3. Investors who are prioritizing earnings-based models in their research would most likely riposte here that AIVL is cheaper that the S&P 500 index on the earnings yield basis, sporting an EY of ~5.6% vs. ~4.77% of the bellwether index. However, as I have already mentioned above, AIVL is benchmarked against the Russell 1000 Value index, and IWD, the fund that tracks it, has an EY of ~6.5% (a Price/Earnings of 15.35x).
4. According to the prospectus, "the equity securities selected by the AI model typically have a lower price-to-book ratio, a lower price-to-earnings ratio, and greater free cash flow." Even though I regard P/B as an outdated metric, I should make a remark that AIVL's WA Price/Book ratio is at 3.2x, as per my calculations, compared to IWD's 2.2x. This is despite ~9.4% trading below the book value (with a sub-1x P/B), mostly financials like American International Group (AIG) and Citigroup (C).
5. Speaking of FCF, ~8.9% of the fund's holdings (with financials removed), mostly utilities, failed to deliver a cash surplus in the last twelve months, consequently, their P/FCF ratios are negative. In this group of companies incapable of covering capital expenditures organically, two are also loss-making, namely Roblox (RBLX) an Intel (INTC). Here I am assuming the reason for this FCF-negative group qualifying for inclusion is their relatively low P/B ratios, which are below the fund's WA figure, with the lowest being Avangrid's (AGR) 0.8x; one exception is RBLX which is trading at a ~68x P/B.

The fund's portfolio has lackluster growth characteristics

With valuation being far from perfect, one might expect robust growth characteristics, contributing to a bit stretched multiples in certain cases. However, AIVL delivers a surprise here, with the weighted-average revenue and earnings growth rates of 3.8% and 3.6%, respectively, as per my calculations. For better context, I should clarify here that such bleak rates are mostly the consequence of ~15% of the holdings forecast to experience earnings contraction going forward and about 12% forecast to deliver lower revenues.

The silver lining: high-quality stories are aplenty

AIVL has a meaningful share of high-quality names in its portfolio, which is barely a coincidence for an equity mix dominated by large caps (i.e., only ~17% are mid and small caps). More specifically, over 87% are boasting sector-leading profitability characteristics (manifested in a Quant Profitability grade of B- and higher).

It would be pertinent to note that the median EBITDA margin for non-financial companies is ~23.9%, as per my estimates, a fairly strong result (for better context, the median for the industrial sector is more than 10% lower), also assuming that just three players, namely RBLX, NovoCure (NVCR), and Palantir Technologies (PLTR) are currently EBITDA-negative.

Final thoughts

Even though machine learning has been a hot topic on the Street for quite some time, especially this year, my principal point is that AI involvement with securities selection, at least at this point, is not synonymous with outperformance. Another way of saying, an AI-driven value strategy is not necessarily better than one based on systematic rules and a carefully implemented protocol, with human analysts selecting stocks using a set of predetermined ratios and deviating from them if necessary, depending on their opinions on price directions and if the protocol allows to do so.

Speaking about AIVL, I would question its value exposure as the analysis above illustrated the portfolio is priced not as attractively as it may. In addition, the weighted-average growth rates look too soft. Quality is a silver lining, but I would not say this alone is sufficient for a Buy thesis, considering a large-cap-heavy mix would have a comparatively strong profitability in most cases as I illustrated in a few articles in the past.