European CLOs secure spot in vast ETF ecosystem

European CLOs are gradually securing their place in the vast ETF ecosystem, with several new CLO ETFs being planned in the coming weeks and months. For CLO fund managers that add an ETF to their offering, this will mean getting used to working at a faster pace and providing extra disclosure.  

The longer-term implications of these new products on the CLO market are, however, not entirely clear. If the US example is anything to go by, CLO ETFs could become a force to be reckoned with. “ETFs are a disruptive technology,” points out Tony Kelly, co-founder of BondBloxx, a US fixed-income ETF issuer that launched a Private Credit CLO ETF in December 2024. “ETFs disrupt the status-quo by levelling the playing field in terms of information and access.”

Europe’s very first CLO ETF — Fair Oaks AAA CLO ETF — was approved in September 2024 by Luxembourg regulators, while January 2025 saw the launch of the Janus Henderson Tabula European AAA CLO UCITS ETF, and a few more CLO ETFs are coming. The main reason for this acceleration is a change of stance in Ireland, where regulators until the end of 2024 did not approve new ETFs investing exclusively in CLOs, says Roger Coyle, a partner at Fair Oaks Capital in London.

Ian Bettney, a portfolio manager in Janus Henderson’s secured credit team, suggests the strong growth of US CLO ETFs has probably put more focus on the viability of the product in Europe.

Quirks of the system
The constant asset growth of the US CLO ETFs has caught the eye of CLO professionals and regulators, but without fully dispelling concerns about the suitability of these products in Europe, which is a smaller and more fragmented market.

Some degree of wariness is understandable. The ETF ecosystem has its quirks, which can baffle fixed-income investors. Terms commonly used in bonds such as "primary" and "secondary" markets do not have the exact same meaning in the ETF space, for example, while actors which sound like unimportant cogs in that latter ecosystem — such as “authorized participants” (APs) — turn out to be vital components of it. Highlighting such differences, Jane Street and Flow Traders are the big hitters in the ETF world, but are unknown in the European CLO market. “The reality is that until recently these two ecosystems evolved separately, and are now just starting to become intertwined,” notes Bettney.

Fair Oaks Capital has published the following diagram to help investors understand how its ETF works. It shows the centrality of APs and market makers which are strategically placed between Fair Oaks’ AAA CLO ETF (FAAA) on the left hand side, and investors on the right hand side:

Source: Fair Oaks Capital, A New Way to Invest in AAA CLOs.

Growing AUMs
Passive ETFs that merely track stock market indices make up the bulk of the ETF market. In contrast, active ETFs implement investment strategies that include an “element of judgment,” as the French markets regulator put it in a recommendation. CLO ETFs sit in this second category.

Assets in active ETFs totaled €54.4 billion in 2024, up from €29.6 billion in 2023, according to Morningstar’s European ETF & ETC asset flows report. Assets in active ETFs account for 2.5% of total assets invested in ETFs in Europe, up from 1.8% in 2023. Within these €54.4 billion of assets, €11 billion was invested in the fixed-income sector.

The capacity of CLO ETFs to attract funds in the US has been impressive. Indeed, the assets under management of US CLO ETFs now exceeds the AUM for broadly syndicated loan (BSL) ETFs, with stronger inflows and deeper trading volumes, according to a BofA Global Research report dated Jan. 31.

In Europe, the Fair Oaks AAA CLO ETF had €139 million of assets as of Jan. 31.

Janus Henderson — which manages the huge JAAA CLO ETF in the US ($19.89 billion in assets as of Jan. 31) — last year bought European ETF specialist Tabula, and launched a European CLO ETF in January. Its Janus Henderson Tabula European AAA CLO UCITS ETF had €111.87 million of assets under management as of Jan. 31.

Elsewhere, Palmer Square Capital Management recently announced plans to launch three CLO ETFs in the European marketplace.

Trading corner
A key distinction in the ETF space is between the primary and secondary markets. The secondary market is the most visible part of this ecosystem, as this is where securities are bought and sold on an exchange (such as the London Stock Exchange, or Deutsche Börse Xetra). Buyers pay for their shares in cash through a broker — but this is only the tip of the iceberg.

Source: JPMorgan Asset Management, Debunking 6 ETF Myths: Actual ETF Liquidity Explained.

The creation of extra ETFs or the redemption of existing ETFs occurs in the primary market. This is also where the bulkier orders from large investors will be dealt with, rather than in the secondary market. Managers of ETF funds such as Fair Oaks and Janus Henderson are only called into action when contacted by the APs, and have no involvement with the secondary market.

In the secondary space, market-makers make two-way prices electronically without relying on two-way order flows, thereby providing liquidity for investors. Neither market-makers nor APs are "trading" in the sense that they would take a long or short position like a proprietary trading desk. Rather, they create and redeem when they are long or short the ETF due to sales or buys from investors.

“Each ETF trade is instantly hedged with the underlying bonds or derivatives, until delivery at T+2 [trade plus two days],” explains Hector McNeil, co-founder & co-CEO of HANetf, a London-based ETF specialist that operates a white-label ETF platform. APs do not have to replicate the underlying bonds, and they often hedge using the most efficient correlated assets. 

ETF redemption or creation orders are typically sent to the ETF issuer by the APs, by 2 p.m. on a trading day. In the case of Fair Oaks’ CLO ETF, the orders will come from either RBC, Flow Traders, Jane Street, Jefferies or Virtu ITG. Then, the process becomes more familiar to CLO players, in that the manager (Fair Oaks or Janus Henderson) just turns to the usual CLO trading desks to sell underlying bonds if they need to raise cash or buy more CLO bonds.

Best execution
Having traditional investment banks acting as APs could create some potential synergies (especially when payments are made in kind, which is not the case now), but the idea remains the same — Fair Oaks as the ETF provider seeks the best execution with the underlying CLO bonds it trades with investment banks, and optimal liquidity for the shares in the ETF primary and secondary markets through agreements with market-makers, explains Fair Oaks' Coyle.

“The way we manage the funds does not really change. What is different is that ETFs offer daily liquidity with same-day notice, which means the notice period for the creation and redemption of ETF shares is shorter than for unlisted UCITS shares,” says Coyle. The aim is to execute the trades on the same day, but there is a little bit of flexibility, he adds, and when there is a sale the cash is delivered at T+2.

“The create/redeem cut-off is a new permutation of daily liquidity, though we manage other funds with daily liquidity with slightly earlier cut-offs, however the differential is immaterial,” says Janus Henderson’s Bettney. In his view, the key is “establishing efficient desk processes and having strong relationships with the CLO trading desks that will allow us to quickly react to flows, regardless of direction, within the remaining trading window.”

When it comes to creating new ETF shares, the “mechanics of the ETF permit any residual inflow to be dealt with over subsequent days if required, while the depth of the market will comfortably realize any potential sales required for a redeem,” Bettney adds.

In addition to tight deadlines, ETFs bring extra work — namely around distributing information, disseminating a daily NAV, and some additional disclosures.

Sales spikes
ETF shares trade at market prices rather than at NAV. This means that an ETF's market price can be different from its NAV, and the interaction between the two — and which one drives the other — is not that clear. In a study carried out in September last year, Barclays analysts found that “credit ETFs tend to lead the cash markets.” In a January report that cites these prior findings, Barclays analyst Pranava Boyidapu said that, should CLO ETFs start to see outflows (which is not Barclays’ expectation), then “going by the analysis in other credit ETFs, we would expect these outflows to impact pricing of CLO tranches and CLO ETF NAVs converging into the ETF market prices” (CLO ETFs continue to grow, Jan. 24). 

On the other hand, CLO managers are confident that the European CLO market has enough depth to cope with potential outflows. “Daily liquidity is not an issue as the large, liquid and deep AAA CLO market has been stress-tested meaningfully — particularly with the LDI experience still in recent memory,” Bettney says. 

In the event of a sudden spike in trading of ETF shares, the swings in their price are likely to be muted, since ETFs trading too high or low relative to the NAV would become an arbitrage opportunity for APs. “If an ETF share trades well above fair value, an AP would notice this, sell the ETF share and then buy a share from us through the ETF unit creation process,” says BondBloxx’s Kelly.  

Meanwhile, a certain amount of trading occurs without the involvement of APs or the ETF provider. “With a mutual fund, all buy and sell trades hit the fund; with an ETF all investors trade in the secondary market and an ETF unit can be traded many times without the need to go to primary to create more units — it is about one in 10 [that need to go up to primary] depending on the products, but there is certainly a lot of recycling of ETFs before an issuer needs to create and redeem units,” HANetf’s McNeil says. “This is a major advantage over mutual funds, which generate significantly more friction.”

According to JPMorgan Asset Management, only 13% of the trading volume of the top-10 US high yield ETFs during a nine-month period ended September 2024 led to primary market flows (From Evolution to Revolution: The Power of Active Fixed Income ETFs).

Stress relief
The argument that ETFs bring volatility is probably the criticism that specialists in this market find most irritating, and they are quick to point out that active intraday trading in ETF shares has proven to be valuable in periods of stress. “Greek ETFs kept trading during the Greek sovereign crisis. Also since bond ETFs came along, the ETF price is often the most accurate price discovery investors can achieve,” McNeil points out.

BondBloxx’s Kelly echoes this view, noting that during volatile times (such as the pandemic or Global Financial Crisis), very large creations and redemptions for ETFs were “effected seamlessly without impacting the other investors in the funds.”

Fair Oaks’ Coyle also says the volatility theme should not be overstated. If a significant part of the investor base in any given asset class is gaining exposure to it through ETFs, the potential for volatility will increase, but the share of CLO ETFs relative to the whole CLO market is very small, he points out — adding that even in the case of the large US CLO ETFs their shareholder base is very granular, which makes a sudden offloading of large blocks of shares unlikely.