ive been harping on about this for about 7 years now but i gotta repeat it because thats my bit, but the CLO market is ripe for disruption by someone daring to do a low-fee indexed structure, especially via synthetics, which may seem counterintuitive, lemme explain...

traditional CLO managers will never do this, it would be like asking a L/S HF to pioneer low-cost indexing. fundamentally incompatible views about the level of value-added by the managers, but a new entrant, primarily one without traditional finance roots, definitely could

first: what the fuck is a CLO at its core? its basically a non-bank relatively unregulated vehicle for credit and (some) maturity transformation and risk aggregation and redistribution. somewhat like what banks used to do but more defined and with a semi-static asset pool.

second: whats the point? well, theres a couple: first, there is the credit transformation angle. you pool moderately information sensitive assets to create some information insensitive assets and some highly information sensitive assets (see also: Gorton, Gary)

this has the positive externality of, via the risk structuring and diversification, transforming liquidity. more liquidity = good. additionally, CLOs allow you to take more specific credit bets. if a loan is a short PUT (merton model), a portfolio of loans is a lot of short PUTs

and a CLO becomes a portfolio of near the money PUT spreads (equity residual) plus a number of short PUT spreads getting further out of the money as tranche seniority rises until the most senior is short DOOMs. (this will make sense in a minute)

so if you want to make a pretty narrow bet on the aggregate outcome, you can. if a loan portfolio is systematically selling LEAP ATM PUTs then a BBB CLO strategy is systematically selling 15-10 delta spreads.

now, recall from your options training that index implied vol is capped by constituent weighted average implied vol in a no-arb framework. so, trating IV as analog to spreads, any static pool of loans trades at either wavg credit spread or lower (depending on implied correlation)

when a bunch of loans can be pooled and structured such that the implied correl is < 1.0 then you can strip out that correlation premia by structuring. the lower credit tranches essentially engage in a short correlation trade (after clearing structure and management frictions)

well, structuring aint cheap (lots of paperwork) but it is ~ fixed and has economies of scale. management cost is variable and if you think HF 2/20 is a ripoff then i have tough news for you about CLO fees. its a hell of a racket to put it mildly

so, lets say you think CLO managers add less value than their fees and most of thr value-added comes from liquidity transformation (the benefits of which scale with size) and diversification. thats not an unfair assumption, its mine tbh

well... what if you disintermediated the managers? yup. right there with you. the problem is you still need to like, buy the loans and maintain the assets. thats like, a lot of paperwork and operations stuff (loan trading is like fax and courier cert delivery levels of efficient)

thats assuming you can even buy the reference pool. you cant just like go out and buy loans willy nilly, getting shut out of deals is a real constraint, just because an asset exist doesnt mean you get to buy it when you want it. it dont work like that

enter: derivatives. loans are finite, the size is the size and whats for sale is all there is. but derivatives? as long as theres a counterparty theres no size or access constraint. no reason why a $500mm loan cant have $3000mm deriv notional outstanding (yah yeah bk arb whatevs)

so lets say its a roaring bull market, spreads are tight and you find some people with bonafide hedging needs or speculative interest in being short credit: boom, you have a counterparty! how convenient because an LCDX position backed by t-bills is operationally a cake-walk

so you eliminate most of the real-world cost of managing a portfolio, all you need is some t-bill management, outsourced collateral management and a few deriv line items (gotta diversify counterparties). this is getting crazy efficient.

but you still have one hurdle: will people buy into your scheme or will existing investors want to stick to the devil they know with active management? well, fuck them, wrap the tranches into a low-cost ETN or CEF wrapper after incubating a few vintages in private markets right

which brings me to my last point: all of a sudden your investor universe explodes in size. 144a private placement CLOs have a limited investor base and also lol good luck with leverage / margin relief unless you are yuge. wrap it in ETP and hello big world and hello cheap margin

all of a sudden any person with a trading account and every retail RIA (ahem) gets to be a player in the CLO game and has the same level of risk granularity that institutions have. oh, and probably a whole lot better margining treatment wouldnt be shocked to see bond funds use it

oh and if you are a fintech disruptor i am 100% available to help you implement this both in CLO market and in CMO market provided you dont need me to wake up before noon west coast time

also... yes... credit and prepayment structuring is the closest thing i know to religion so obviously i am always optimizing for maximum potential system-wide leverage. you wouldnt expect a dog to turn down a treat due to diet concerns, dont expect a structure guy to go macropru