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On this page I've found the following statement:

Taxes on actively managed funds can be considerably higher than those on index funds.

Why is that the case? Since both fund types consist of the same type of stock.

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    Not that Lagerbaer is wrong, but if you wait a couple of days before you mark it correct, then you will get some other answers to compare. There isn't much incentive to answer a question that already has an accepted answer. – MrChrister Jun 2 '13 at 17:38
  • That's true and I'm not even mad :) – Lagerbaer Jun 2 '13 at 18:14
  • The taxes in this instance are the taxes that the share-holders in the fund pay, since as a matter of policy, mutual funds distribute all dividends paid by the stocks they hold as well as the net capital gains from the sales of the stocks they hold (though not the net capital losses!) to the shareholders in the fund so that the fund does not have to pay taxes on this income. – Dilip Sarwate Jun 2 '13 at 22:05
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This depends on the particular index, of course. Capital gains taxes occur when stock is sold (for a profit). This occurs less frequently in an index fund: Where an active manager frequently buys and sells stocks (after all, he wants to be active :-) ), the index fund only sells stocks when the particular stock leaves the index. For an index such as the S&P 500 this does not happen that often.

The more specific the criteria of the index fund, the more often the selling of stock and thus the need to pay capital gains taxes occurs.

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    +1 As a minor comment, "the index fund only sells stocks when the particular stock leaves the index" is not quite true. On any given day, if the total amount redeemed by shareholders of the index fund on that day exceeds the total amount purchased by (other) current shareholders or new shareholders on that day (and the difference is too large to be covered the "small" amount of cash the mutual fund is holding as a buffer against such contingencies), then the mutual fund must sell some shares of the stocks that it holds. So, the manager must decide which stocks to sell (continued) – Dilip Sarwate Jun 2 '13 at 21:57
  • (continuation) since shares are usually sold in round lots (multiples of 100 shares). It is not the case that the manager will sell 0.xyz shares of 500 different stocks so as to track the index (S&P 500 used as an illustration) as closely as possible. – Dilip Sarwate Jun 2 '13 at 21:59
  • The S & P 500 does have more than a few changes each year, though generally these are a small percentage of the overall fund as the stocks removed are due to not representing that much. For example, the last change was on May 23, 2013 with Dean Foods being removed and a month earlier MetroPCS was acquired by T-Mobile on April 24, 2013 for a couple of recent changes. – JB King Jun 3 '13 at 16:18
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First, consider what causes taxes to apply to a mutual fund, index or actively managed. Dividends and capital gains are generally what will be distributed to shareholders given the nature of a mutual fund since the fund itself doesn't pay taxes. For funds held in IRAs or other tax-advantaged accounts, this isn't a concern and thus people may not have this concern for those situations which can account for a lot of investing situations as people may have 401(k)s and IRAs that hold their investments rather than taxable accounts.

Second, there can be tax-managed funds so there can be cases where a fund is managed with taxes in mind that is worth noting here as what is referenced is a "Dummies" link that is making a generalization. For taxable accounts, it may make more sense to have a tax-managed fund rather than an index fund though I'd also argue to be careful of asset allocation as to maintain a purity of style can require selling of stocks that grow too big and thus trigger capital gains,e.g. small-cap and mid-cap funds that can't hold onto the winners as they would become mid-cap and large-cap instead of representing the proper asset class.

A FUND THAT PLAYED IT SAFE--AND WAS SORRY would be a Businessweek story from 1998 of an actively managed fund that went mostly to cash and missed the rise of the stock market at that time if you want a specific example of what an actively managed fund can do that an index fund often cannot do. The index fund is to track the index and stay nearly all invested all the time.

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