The Dawn of Passive Investing: CLO Special Report

Research evidence excerpt

The Dawn of Passive Investing: CLO Special Report

ing constraints – but is common across fixed

income markets by implementing a relatively small set of highly liquid instruments to

deliver benchmark-like return behaviour with an acceptably low tracking error. This is

relevant not only for traditional passive mandates like index funds, ETFs, and LDI-style

accounts, but also for investors using replication as a practical way to stay benchmark-

aware without holding the full universe.

• The Odyssey of Tracking Error. Building on our prior work replicating CLOIE AAA

returns with a theoretical 400-tranche portfolio, we now restrict the universe to the 20

most liquid US CLO managers based on observed BWIC volume. This is just one simple

approach – and it naturally skews toward larger platforms regardless of credit perfor-

mance – but the liquidity screen meaningfully improves index fit without sacrificing

return: Liquid 20 (400 positions) delivers ~24bp tracking error, nearly half the ~48bp

unconstrained baseline and below our 60bp TE target.

• The usual suspects. Passive can raise concentration risk, but investors can manage it

with CLOIE manager baskets, issuer/sector caps, manager diversification and tranche

selection. The bigger risk is hidden overlap: SPV diversification doesn’t prevent the

same issuers/sectors from showing up everywhere, so look-through monitoring matters.

Today, that is most evident in CLO/loan software; by contrast, AI Hyperscaler supply

is heavy in US High Grade, but that market’s depth makes concentration risk less of a

concern (link).

Replication FAQ

Previously, we tested a simple proposition: can a rules-based replication basket deliver

index-like returns for the US CLOIE AAA without needing to hold the full universe? We