Cautious Investors Mount a Retreat

Japanese stocks are off 7.5 percent in the past month. Investors expect interest rates there to rise this year. (By Shizuo Kambayashi -- Associated Press)

And as borrowing costs rise, heavily leveraged investors grow more vulnerable, Gross said. "No doubt, there is more [systemic] risk today than six months ago."

A factor in the current situation is that the prices of stocks, bonds, raw materials, real estate, collectibles and other investments rose in recent years while central banks in the United States, Europe and Japan held interest rates very low to spur economic growth, pumping more cash, or "liquidity," into the world economy.

Much of that extra money flowed into hedge funds, the lightly regulated and often heavily leveraged private investment funds for investors willing to take greater risks in search of greater returns. And relatively low rates of return in the industrialized world prompted many investors to "reach for yield," seeking better returns by putting their money into riskier investments, such as those in emerging markets.

At the end of the first quarter, hedge funds that specialized in emerging markets had $50.4 billion in assets under management, up 245 percent from the $14.6 billion in that sector three years earlier, according to Hedge Fund Research Inc. That's significantly faster than the already explosive growth of hedge funds in general. Total hedge-fund assets rose 182 percent over the same period, to $1.81 trillion from $640 billion.

Now, borrowing costs are rising. "In a nutshell, the era of easy and abundant global liquidity is coming to an end -- a change in the global monetary backdrop that usually inflicts pain on the asset class highly dependent on easy money -- the emerging markets," Joseph Quinlan, chief market strategist for Bank of America's Investment Strategies Group, wrote in a recent analysis for clients.

Much of the recent price run-ups in emerging-market assets and commodities was driven by "momentum investors," who place their money in anything going up and then sell when the price stops rising, analysts said.

"A lot of this was momentum players, just like the momentum players were in the Nasdaq six years ago because that was what was going up," said Harvey Hirschhorn, Bank of America's chief portfolio strategist. "As soon as it stopped going up, they headed for the hills."

And hedge funds had done well this year until May, Gross said. Now that they "see a little bit of risk at the fringe, they pull back to lock in their gains for the year."