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Model ETF Portfolios Get a Fixed-Income Overhaul

Impending changes at PIMCO Total Return ETF prompt changes in these portfolios' bond stakes.

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 PIMCO Total Return Active ETF (BOND) is one of the largest actively managed ETFs, and it has been the largest bond holding in my ETF model "bucket" portfolios as well. But recent changes to its investment guidelines have prompted me to swap the fund for a more plain-vanilla index ETF.

I've also made some changes to the portfolios' smaller, noncore fixed-income positions, to better align them with our ETF analysts' current take on the best options within categories like bank loans and junk bonds. (Spoiler alert: The "best" options aren't always ETFs--even for my ETF portfolios.) While the portfolios' original holdings are still reasonable, the fact that Morningstar's team of passive researchers is constantly conducting new research and bringing new ETFs under coverage makes it worthwhile to review the portfolios' exposures, and suggest changes, on an ongoing basis.

Here's an overview of the changes; these adjustments are also reflected in the individual ETF portfolio discussions. (You can find the Aggressive, Moderate, and Conservative ETF Bucket portfolios here, and the Aggressive, Moderate, and Conservative Saver ETF portfolios, as well as other model portfolios, on the main page for my model portfolios.)

Core Fixed Income
Change from: PIMCO Total Return Active ETF
Change to:  iShares Core Total USD Bond Market (IUSB)
Portfolios affected: ETF Bucket Portfolios (Aggressive, Moderate, Conservative) and ETF Saver Portfolios (Moderate, Conservative)

As senior analyst Eric Jacobson outlined in his recent analyst report, PIMCO will be changing the mandate of PIMCO Total Return Active ETF in early May; the fund's name will also change to PIMCO Active Bond Exchange Traded Fund. The goal of the changes, he notes, is to make the fund more attractive to investors seeking regular income distributions. Toward this end, PIMCO will increase its allowable weighting in noninvestment-grade bonds to 30%, up from 10% currently. Meanwhile, the fund's limits on nondollar-denominated bond and currency plays will fall; Jacobson points out that such plays may boost returns, but they don't contribute to yield and therefore don't align with the fund's heightened income focus.

In keeping with the adjustments to its investment guidelines, PIMCO Total Return Active ETF will get a new management team. Scott Mather, Mark Kiesel, and Mihir Worah will still run the firm's open-end flagship  PIMCO Total Return (PTTRX), but David Braun, Jerome Schneider, and Dan Hyman will replace them on the ETF.

While Morningstar thinks highly of PIMCO's fixed-income team, these changes introduce some uncertainty here, and to the portfolios. The goal of the core bond positions in my bucket portfolios is to provide "ballast" for the more aggressive equity and fixed-income holdings. With a strategy that allows greater leeway to own high-yield bonds, there's a risk that PIMCO Active Exchange-Traded Fund won't fulfill that role of equity shock absorber as well as a portfolio with tighter parameters around noninvestment-grade bond exposure. Given not-cheap equity valuations, I think there's a realistic chance that true high-quality bond ballast will be needed within the next few years.

In lieu of the position in PIMCO Total Return Active ETF, I'm swapping in iShares Core Total USD Bond Market, a passively managed ETF that charges 0.08%. A total bond market index ETF like Vanguard Total Bond Market would also be a reasonable choice, but I like that the iShares ETF contains exposure to the entire credit spectrum without going overboard on lower-quality bonds. Its weighting in noninvestment-grade bonds is currently less than 10% of assets. In the interest of consistency, I'm swapping in the iShares fund in place of  Vanguard Total Bond Market (BND) in my model Saver portfolios as well. While the Vanguard fund remains a perfectly solid holding, I like that IUSB gives the Saver portfolios some noninvestment-grade exposure, especially because the they don't have a dedicated position in high-yield bonds.

In addition to the changes to the core fixed-income position, I'm making some other changes to the bucket portfolios' bond stakes, as follows.

Bank-Loan
Change from:  PowerShares Senior Loan ETF (BKLN)
Change to:  SPDR Blackstone/GSO Senior Loan ETF (SRLN)
Portfolios Affected: ETF Bucket Portfolios (Aggressive, Moderate, Conservative)

There are a handful of areas where Morningstar's passive strategies analysts believe that active funds can serve a valuable role, and the senior loan/floating-rate-loan area is one such spot. The reason is that active managers have the latitude to invest in less-liquid loans and actively manage credit risk, something that passively managed products have less flexibility to do. (You can see Morningstar's favorite actively managed senior-loan funds here.) I'm retaining an ETF for this slot in the portfolio, but replacing PowerShares Senior Loan with SPDR Blackstone/GSO Senior Loan ETF. Alex Bryan, director of Morningstar's passive strategies research for North America, notes that SRLN is only slightly more expensive than the PowerShares product (0.70% versus 0.65%) and it actively manages credit and liquidity risk.

Noninvestment-Grade Bond
Change from:  SPDR Barclays High Yield Bond (JNK)
Change to:  Vanguard High-Yield Corporate (VWEHX)
Portfolios Affected: ETF Bucket Portfolios (Aggressive, Moderate, Conservative)

Like the senior-loan sector, the high-yield bond segment doesn't lend itself well to passive strategies. (Alex Bryan does a deeper dive into the shortcomings of ETFs in the high-yield sector in this article.) Bryan believes active funds have a leg up on passive in this area because they can pay attention to liquidity issues and pricing when they trade, valuable assets in the illiquid high-yield market. The trade-off is that active funds can cost more than their index counterparts. Yet Vanguard High-Yield Corporate, an active fund, charges less than its passive alternatives; it also has less exposure to low-quality credits than index alternatives. It may seem peculiar to use an active fund in ETF portfolios, but the investment merits of active funds outweigh the drawbacks.

Emerging Markets Bond
Change from: WisdomTree Emerging Markets Local Currency Debt (ELD)
Change to: iShares JPMorgan USD Emerging Markets Bond (EMB)
Portfolios Affected: ETF Bucket Portfolios (Aggressive, Moderate, Conservative)

My original bucket portfolios includes a small stake in a local-currency-denominated emerging-markets bond fund, WisdomTree Emerging Markets Local Currency Debt, with the goal of extra income and a bit of diversification. However, currency fluctuations can make nondollar-denominated bond funds behave more like equities than like bonds. For that reason, Morningstar's passive researchers prefer hedged products that negate the effects of foreign-currency fluctuations relative to the dollar. I'm swapping in iShares JPMorgan US Dollar Emerging Markets Bond in place of the unhedged product; the iShares fund has the additional advantage of lower expenses.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.