Europe’s first exchange traded fund investing in collateralised loan obligations is due to list tomorrow, five years after regulators appeared to tighten restrictions on new Ucits funds wholly invested in the asset class.
The listing of the Fair Oaks AAA CLO ETF (FAAA) comes in the wake of surging demand for similar ETFs in the US, where net inflows into CLO ETFs hit a record $8.3bn in the first seven months of 2024, according to data from Morningstar Direct, more than double last year’s full-year tally and five times that of 2022.
Assets held by Wall Street’s 10 CLO ETFs has jumped to $14.8bn — seven times the $2.1bn they held at the end of 2022, according to Morningstar.
The underlying building blocks of CLOs are floating-rate corporate loans, often to private equity-backed companies, typically with subinvestment grade BB or B credit ratings.
These loans are then securitised, ie bundled up into pools of debt. This allows a CLO manager to slice the pools into tranches with varying degrees of risk, which can then be sold to third parties such as banks and asset managers.
However, in 2019 European regulators tightened their imposition of restrictions on investment in CLOs by Ucits funds, according to industry participants.
Most US CLOs were judged not to be Ucits compliant due to a failure to meet so-called risk retention rules.
Separately, the maximum exposure to European CLOs and those US ones deemed to be compliant, was also unofficially capped, industry figures say.
“The default was 10 per cent, but national regulators can go higher. Some [funds] have been allowed to go to 25-35 per cent, but that is it,” said Michael John Lytle, chief executive of London-based Tabula Investment Management, whose parent company Janus Henderson manages the two largest US CLO ETFs, with combined assets of $12.8bn.
No new European CLO mutual fund has appeared since 2020.
“[CLOs] were deemed by CBI [the Central Bank of Ireland, the country’s fund industry regulator] and Luxembourg as assets requiring higher scrutiny when they are included in Ucits funds. There were deemed to be challenges around liquidity and possible credit exposures,” said Lytle.
Pre-existing mutual funds were, though, permitted to continue operating with 100 per cent CLO exposure under a “grandfathering” clause.
This has allowed the Fair Oaks ETF to overcome the restrictions by dint of being an ETF share class of a €161mn Luxembourg-domiciled actively managed mutual fund launched in 2019.
It will only buy the most senior AAA-rated tranches, none of which have ever defaulted since being introduced in 1997, according to S&P Global Ratings.
“Our core belief is that the CLO market generates consistent, repeatable and superior risk-adjusted returns over multiple market cycles versus other credit strategies,” said Miguel Ramos Fuentenebro, co-founder and partner at Fair Oaks Capital, which manages $3bn of assets.
“We have seen growing interest from investors in the US, and we believe this will be the case in Europe as well.”
Roger Coyle, also a co-founder and partner at Fair Oaks, accepted there was a “perception of complexity” around CLOs and that “regulators are cautious about approving CLO investment in vehicles that are typically more retail oriented”, even though in Fair Oaks’ case it is not targeting the “mass retail” market.
However, Coyle argued that CLOs, which are exchange listed but traded “over the counter”, are “very liquid” and highly unlikely to default.
“You have to model hugely unrealistic scenarios where the whole corporate loan market defaults [for a AAA CLO default],” Coyle said.
Lytle believed there were “misperceptions” around CLOs, partly due to “three-letter acronym blight”, a reference to them being associated with collateralised debt obligations, or CDOs, which were central to the global financial crisis due to their holdings of subprime mortgages, which CLOs do not hold.
“CDOs were implicated in the 2008 GFC but [CLOs] are very different things. Their structure is quite different,” Lytle said.
“It would require an 80 per cent default rate to trigger a default” in a AAA-rated CLO. “I don’t think people who know anything about the structure are concerned about defaults,” Lytle added.
Instead, he believed regulators were more concerned that less sophisticated investors might not understand why CLO funds sometimes suffer trading losses, as they perhaps might do more readily with simpler assets such as equities.
“It’s a belt-and-braces concern. If you analysed the situation then you would conclude that there isn’t a problem,” added Lytle, who said the European CLO market was now around $250bn, a quarter of the size of the US.
The Fair Oaks ETF is described as a Euribor +1.3 per cent product. The mutual fund returned 1.7 per cent in 2020, Coyle said, 0.5 per cent in 2021, lost 2 per cent in 2022 as spreads widened, made 6.8 per cent in 2023 as spreads tightened again, and has returned 5 per cent in the first seven months of 2024, all in euro terms.
As for the wisdom of buying floating-rate debt at a time when interest rates are falling, Ramos said “we are not trying to time the market” and that the expectation of lower rates “is already priced in”.
Kenneth Lamont, senior fund analyst for passive strategies at Morningstar, said “complicated markets require significantly more diligence” on the part of investors.
Nevertheless he welcomed the launch. “This is what ETFs do well. They represent this force for the democratisation of finance. This is just another step in the ladder and I think it should be applauded,” Lamont said. “It’s positive, it’s more choice — access to different asset classes.”
The ETF is scheduled to list on Deutsche Börse’s Xetra exchange on Wednesday and on the London Stock Exchange “shortly thereafter”, with a total expense ratio of 0.35 per cent.
