Bill Gross warns mutual funds, hedge funds, ETFs vulnerable in liquidity pullback

NEW YORK (Reuters) - Bond investing guru Bill Gross on Tuesday warned investors and markets that mutual funds, hedge funds and exchange-traded funds are most vulnerable when liquidity becomes scarce.

In his latest investment outlook, Gross said that global markets have benefited massively from trillions of dollars of liquidity over the past few years stemming from the Federal Reserve and other major central bank's loose monetary policies, but warned of sharp price moves in certain markets should that liquidity begin to dry up.

“Mutual funds, hedge funds, and ETFs, are part of the 'shadow banking system' where these modern 'banks' are not required to maintain reserves or even emergency levels of cash,” said Gross, who oversees the Janus Global Unconstrained Bond Fund.

“Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401ks or institutional pension funds and insurance companies, would find the 'market' selling to itself with the Federal Reserve severely limited in its ability to provide assistance.”

Gross said while Dodd-Frank legislation has made actual banks less risky, their risks have really just been transferred to somewhere else in the system.

With trading turnover having declined by 35 percent in the investment grade bond market and 55 percent in the high-yield market since 2005, “financial regulators have ample cause to wonder if the phrase 'run on the bank' could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks,” Gross said.

Analysts say the anticipated interest rate hikes by the Fed, combined with the Fed's ending of bond buying via the ceasing of quantitative easing programs in 2014, are exacerbating already thinning liquidity stemming from tighter bank regulation and a change in bank business models.

That has magnified price moves in many fixed income markets, even the generally safe and steady areas such as top-rated government bonds.

Gross said what could precipitate a "run on the shadow banks" include a central bank mistake, leading to lower bond prices and a stronger dollar; Greece, and if so, the inevitable aftermath of default and restructuring leading to additional concerns for euro zone peripherals; China, which Gross calls "a riddle wrapped in a mystery, inside an enigma" and "mystery meat" of economic sandwiches; an emerging market crisis; and geopolitical risks, which are "too numerous to mention and too sensitive to print."

All told, Gross said hold an appropriate amount of cash "so that panic selling for you is off the table."

(Reporting By Jennifer Ablan; Editing by W Simon and Meredith Mazzilli)