(Bloomberg) -- A recent deluge of cash into ETFs tracking US collateralized loan obligations is spurring money managers to try to replicate the model in Europe. 

Talks between investment firms and European regulators both in Ireland and Luxembourg are already underway and engagement is high from all parties, according to two people with knowledge of the matter, who asked not to be named as talks are private. Separately, Janus Henderson, the dominant player in the US market, recently acquired European ETF provider Tabula to help facilitate the trade. 

Strong performance relative to other assets helped CLO issuance skyrocket in May, making it the busiest month for sales in two and a half years. But currently the investment vehicles, which repackage leveraged loans and bundle them into bonds, are only accessible to institutional investors in Europe because they aren’t available to buy in small volumes. 

“It’s important to open the CLO market to a new class of investors that historically have not been able to get access,” said Laila Kollmorgen, a managing director at PineBridge Investments, which co-runs the US-based VanEck CLO ETF. “What an ETF does is to provide access to smaller institutions.”

CLOs have posted unprecedented returns on their riskiest portions, while the safest tranches have consistently outperformed rival asset classes so far this year. European AAA total returns stand at 3.6% year-to-date, according to Barclays data, compared with 0.6% for investment-grade bonds. 

In the US, where ETFs tracking the instruments have existed since 2018, money is pouring in. Twelve funds followed by Bloomberg have attracted $6 billion so far in 2024, equivalent to over half the inflows of the last three years. Janus Henderson recently broke through the $10 billion mark with its flagship vehicle. 

“Growth has been very brisk, perhaps faster even than people expected,” said William Sokol, director of product management at VanEck Associates Corp. “This was for a few reasons, such as a very favorable market, the repricing of rate-cut expectations, the higher-for-longer environment. It all added up to the strong performance over the last few years.”

Bumpy Road

The stellar performance, however, offers no guarantee that European regulators will accede to fund managers’ pleas. Approval would require the funds to comply with the framework on Undertakings for Collective Investment in Transferable Securities, the key retail investment product in the European Union. 

Prospective managers will have to prove that the CLO market is suitable for retail investors, the people familiar said. In other words, whether the asset class is liquid and scalable enough to weather idiosyncratic events. 

“ETF managers have to make sure that they provide enough evidence to mitigate regulator concerns around scalability and liquidity of the market, as well as to consider the level of access for retail and institutional investors,” said Denis Struc, a portfolio manager at Janus Henderson.

The European Securities and Market Authority declined to comment. Spokespeople for the Commission de Surveillance du Secteur Financier, which supervises the Luxembourg financial sector, and the Central Bank of Ireland declined to comment. 

Liquidity Factor

Regulator anxiety might focus on the mismatch in liquidity levels. While ETFs are vehicles that allow investors to pour money in and withdraw quickly, CLOs are sold in auction processes called bid-wanted-in-competition, which normally take a couple of days to clear. Liquidity is mainly provided by asset managers buying the paper, instead of trading desks and exchange platforms.

Money managers argue that this liquidity mismatch hasn’t played out in practice and that the CLO market has proved highly liquid during market dislocations compared with other asset classes.

“If we compare investment-grade and high-yield bonds with CLOs, there is no evidence of a reduced level of liquidity in the latter,” said Janus Henderson’s Struc.

Others note that ETFs can actually provide liquidity and price discovery in periods of volatility when trading volume in the secondary market increases. That allows investors to add, reduce or hedge risk during market selloffs, even if trading in the underlying securities becomes less liquid. Also, derivatives on ETFs can be created that allow for additional ways to go long or short, and ETF shares themselves can be shorted.

“To have the ability to short cover means that you have capacity to minimize market volatility,” said Kollmorgen at PineBridge. “What you are doing is creating a market environment where drawdowns are shallower than historically. When you look at other markets, such as equity, when there is a sell off, people are ready to invest more money.” 

Educated Investors

There’s also an argument that European retail investors aren’t as educated on products like these as their US counterparts, potentially creating less demand for a CLO ETF market in the region. Investors will need to be able to demonstrate “specialist knowledge” such as an ability to understand liquidity, risk retention and disclosure requirements, according to Janus Henderson’s Struc. 

He foresees the market in Europe being more of a mix of institutional and retail investors, whereas in the US it’s more retail focused. Citigroup analyst Charles Kellett voiced a similar opinion during a panel session at the recent Invisso Global ABS conference in Barcelona.

“There is a difference between Europe and the US,” Kellett said. “The US retail base is more comfortable with ETFs and it will take a while to see similar inflows here.” 

--With assistance from Laura Noonan, Nicholas Comfort and Jennifer Duggan.

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