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Because dividends and interest earned in mutual funds and capital gains are all passed down to the fund’s shareholders, they are com- pletely taxable to the mutual fund’s investors. The mutual fund itself doesn’t pay the taxes. Therefore, tax-managed funds try to minimize the amount of dividends, interest, and capital gains that are passed down to its shareholders. The funds do this in a number of ways.

First, the fund may elect to concentrate on lower-yielding securi- ties. By choosing investments that aren’t focused on providing cur- rent interest and dividend income, the funds won’t wind up passing that income on to their shareholders, who in turn would wind up pay- ing taxes on it. This means that the funds would then be favoring more growth-oriented securities. Second, the funds may try to reduce the distribution of capital gains. They achieve this by adopting a buy- and-hold stance on the securities, rather than a buy-and-sell approach. This minimizes the turnover in the underlying securities. Third, tax-managed funds may elect a tax-efficient selling policy. This means that when the funds sell some of their appreciated secu- rities, they pick the ones that will have long-term capital gains, instead of short-term capital gains. The long-term capital gains tax rates are more favorable than the short-term tax rates. They will also try to pick the securities that have the highest tax base when selling. Often times when selling, the fund will try to offset any gain with a tax loss, which also minimizes the amount of gain that is passed on to the shareholders. These funds may be appropriate for investors who are in higher tax brackets.

Index Funds Index funds track whatever unmanaged stock indices the funds fol- low. There are index funds that follow the S&P 500, the Russell 2000, the Wilshire 5000, and many others. But that doesn’t mean that index funds are limited just to common stock indices. They can invest in bonds and other securities, too. These funds are categorized as passively managed funds because the funds’ portfolios reflect the individual indices. The other mutual funds we’ve discussed are con- sidered to be actively managed funds because the fund managers pick the securities they think will outperform the market. They then buy and sell the securities in accordance with their projections. With

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