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The only think I can think of is that the funds sold holdings for a gain and then distribute those gains to the funds shareholders proportionally based on the number of shares you hold. Then they automatically reinvest those funds into you account as additional shares. Am I on the right track?

Yes, IF you select to have your distributions re-invested. Some folks take them in cash and use them for other purposes, e.g. to rebalance or for income, etc. is something to be aware of as down the road you may want to use this option.

A key point here is that a mutual fund itself does NOT pay taxes, but passes this onto shareholders. Now, if you hold the fund in an IRA-like account then there aren't any taxes to be paid on this.

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