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Vanguard Sector Funds Get Facelift

NEW YORK (TheStreet) -- At the close of February, Vanguard altered the benchmarks on its family of index-backed sector exchange-traded funds and mutual funds.

Vanguard made these changes to make the funds more tax friendly and to make them more closely track their respective indices.

Before the switch, Vanguard's sector ETFs and mutual funds tracked traditional MSCI sector indices, which weigh individual companies from their respective sectors based purely on stock market values.

Although this is the most efficient way to ensure that the indices provide the most realistic view of the actual makeup of the market, using them to create ETFs raises red flags with the IRS.

To prevent a fund from becoming too heavily weighted in a small number of holdings, the IRS has implemented a number of diversification rules that ETF and mutual fund providers must comply with in order to qualify for favorable tax treatment. Failure to meet these requirements results in double taxation.

In order to be meet these diversification standards, any individual fund constituent cannot account for more than 25% of the ETF or mutual fund's total portfolio, and no more than 50% of a fund's total index can be represented by individual holdings that each account for more than 5% of the fund's total index.

These rules pose a problem for Vanguard's ETFs that are designed to track individual sectors through the MSCI indices.

In a number of instances, a market slice is largely dominated by a small number of companies. For example, the lion's share of the U.S. telecommunications industry is made up of AT&T (T) and Verizon (VZ).

Therefore, an index like the MSCI US Investable Market Telecommunication Services, which underlies the Vanguard Telecommunication Services ETF (VOX) and the Vanguard Telecommunication Services Index Fund (VTCAX), has a lot more than 25% of its portfolio allocated to each of these two companies.

Unfortunately, due to the IRS' stipulations, VOX and VTCAX cannot simply copy this index. Rather, the two instruments are forced to alter their holdings by underweighting large companies like AT&T and Verizon and overweighting smaller holdings. This ultimately leads to large tracking errors that undermine the transparent nature of ETFs.

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