Investors were pulling out of Pimco's popular Total Return bond fund (PTTAX) in droves even before Bill Gross suddenly jumped ship on Sept. 26.

It had a bad 2013 and events went down from there. Morningstar followed, on Sept. 30, by downgrading the fund's analyst rating from gold to bronze, based on the outflows and management upheaval caused by Gross's exit. Then the company shocked followers again by confirming that its flagship fund lost $23.5 billion in the first nine months of this year. No wonder people are fleeing.

“There aren't too many 401(k) or individual account investors, who didn't own a Bill Gross managed fund,” surmises Kevin Mahn, president and chief investment officer of Hennion & Walsh Asset Management. And, the Parsippany, N.J.-based RIA firm, expects outflows will continue if institutional investors follow individuals and move their massive accounts.

“The question is when will the bleeding stop?” asks Todd Rosenbluth, who is S&P Capital's director of ETF & Mutual Fund Research. His team “imagines advisors and RIAs are asking themselves, 'What do I do now that Pimco has new leadership for the total return fund?'” Both he and Mahn speak highly of Pimco's new co-management approach, consisting of Scott Mather, Mark Kiesel and Mihir Worah, who Rosenbluth credits with having “excellent track records.” Co-management can mitigate some manager risk, they say.   

But Mahn also sees the moment “as an inflection point for the investment community. Moms and pops across the country are probably wondering whether their mutual fund is in danger of the manager leaving and going elsewhere.” The situation, he says, may motivate more investors to move to passive, likely ETF alternatives.

If they choose the ETF route but want to try to keep something close to the mix in PTTAX, Rosenbluth has a strategy that, he says, advisors and RIAs can implement that would seek to replicate Gross's prize Total Return fund without the manager risk or higher active expense rates. PTTAX has an expense ratio of 0.85 percent and the Pimco Total Return ETF has an expense ratio of 0.55 percent, according to Morningstar.

The PTTAX, as of the end of August, had 41 percent in government-related securities, 20 percent in mortgages, 13 percent in U.S. credit, another 13 percent in non-U.S. developed countries, and 9 percent in emerging markets. Rosenbluth theorizes that the remaining securities may have been preferred stocks and convertible bonds. These levels may be very different when Pimco releases last quarter data. But the duration of the fund was 5.4 years, with 30-day SEC of 1.9 percent.

Under the Rosenbluth strategy, the U.S. government intermediate bond portfolio would be replaced with iShares 3- to 7-year Treasury ETF (IEI). IEI has a low 0.15 percent expense ratio and a duration of 4.5 years, which is lower than the PTTAX.

For mortgage holdings, Rosenbluth suggests substituting the Vanguard Mortgage Backed Securities Index (VMBS 52 Overweight). The ETF has a low expense ratio of 0.12 percent and a duration of 4.4 years, and a 30-day SEC yield of 1.4 percent.   

Ishares iBOXX Investment Grade Corporate (LQD 118 Overweight) would provide the U.S. corporates. It has 0.15 percent expense ratio, a 30-day SEC yield of 3.0 percent and a duration of 7.7 years.
Non-U.S. bonds would be provided by the Vanguard Total International Bond Market (BNDX 52 Marketweight), the youngest of the six ETFs Rosenbluth proposes, having launched in May 2013. It has a 0.20 percent expense ratio and offers mainly developed-market sovereign bonds, such as Japan and France. The fund has a 30-day SEC yield of 1.2 percent and a higher duration than other ETFs at seven years.

Emerging market exposure could come from PowerShares Emerging Markets Sovereign Debt (PCY 28 Marketweight). It carries the highest expense ratio, 0.50 percent and a 30-day SEC yield of 4.5 percent, partially offset by a duration of 8.8 years.

Active manager risk is completely mitigated with an ETF, says Rosenbluth. “The risk is that investors may not be qualified to make asset decisions. It requires an advisor steering that allocation process.”