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

In his latest investment outlook last week, he said 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 banks' 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 Mr 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... would find the 'market' selling to itself with the Federal Reserve severely limited in its ability to provide assistance."

Mr Gross said while Dodd-Frank financial reform legislation has made actual banks less risky, their risks have really just been transferred somewhere else. With trading turnover having declined by 35 per cent in the investment grade bond market and 55 per cent 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", he 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 programmes last year, 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.

Mr 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 the inevitable aftermath of default and restructuring leading to additional concerns for euro zone peripherals; China, which he calls "a riddle wrapped in a mystery, inside an enigma" and the "mystery meat" of economic sandwiches; an emerging market crisis; and geopolitical risks, which are "too numerous to mention and too sensitive to print".

REUTERS