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Bill Gross warns on potential liquidity issues for hedge funds, mutual funds and ETFs

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Legendary fund manager, Bill Gross, writing in his monthly outlook for Janus Capital Group, comments on liquidity, or lack thereof, in the financial markets, drawing parallels with Californian drought restrictions.

Gross highlights concerns around the shadow banking activities of mutual funds, hedge funds and ETFs. “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” he writes. “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.”
 
He argues that post crisis, the Fed and other central banks imposed emergency liquidity provisions of their own – in effect they became the buyers of last resort. “Recently however, Congressional legislation concerning ‘too big to fail’ and Federal court rulings in favour of AIG regarding the expropriation of shareholders’ capital, have cast doubts as to whether central banks and their governments can exercise similar ‘puts’ in the future to stabilize asset prices.”
 
As a result, Gross observes that regulators are proceeding with ‘better safe than sorry’ mandates – tightening bank capital standards, curtailing the size of the potentially volatile repo market from USD4 to USD2 trillion, and pursuing inquiries as to which financial institutions are “strategically important” – code for ‘big enough to threaten asset market stability’.
 
He writes: “Not only major banks but several insurance companies and asset managers including PIMCO – just one block down the street – are being scrutinised. These individual companies which include Prudential, MET, BlackRock, and at least several others have responded as you might expect. ‘No problem’ sums it up – markets are a little less liquid they claim, but recent experience would show that for PIMCO at least, there were no ‘fire sales’ or ‘forced selling’ after my recent departure, as stated by CEO Doug Hodge in a friendly WSJ article. Ah now I’ve caught your interest.”
 
Gross says that the PIMCO example is not a good one to use to prove the current liquidity of mutual funds, ETFs, and even index funds. “Hodge himself admitted to internal proprietary ‘liquidity’ provisions, adding that it used derivatives for exposures ‘to support cash buffers and inflows’ (sic). The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk – presenting possible exit and liquidity problems in future months and years” Gross says.
 
He continues: “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 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. Thus, current discussions involving ‘SIFI’ designation – ‘Strategically Important Financial Institutions’ are being hotly contested by those that may be just that. Not ‘too big to fail’ but ‘too important to neglect’ could be the market’s future mantra.”
 

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