Two Myths About Equity Funds

There are two myths about equity funds: [1] management may be forced to sell some fund holdings because of increased redemptions during bear markets (thereby triggering unwanted capital gains) and [2] embedded capital gains for equity funds can eventually trigger unwanted gains (particularly to newer investors who did not enjoy the previous appreciation that is now called “embedded”).

The answer to both of these myths is the same—cash flows for equity funds are usually positive (e.g., during the 2000-2002 meltdown, $62 billion of new cash went into equity funds; in 2008, 31% billion went into equity funds). This positive cash flow means management can use the incoming cash to satisfy redemptions (without having to sell positions in the portfolio). Moreover, fund management is buying lots of stocks over a number of years. If stock positions need to be liquidated, a fund manager can sell off positions that result in losses that can later be used by the fund to offset gains.