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.

The importance of keeping tracking error to the minimum is highlighted by Vanguard's success with its emerging-market ETF.

Over the past few months, investors have been fleeing from the iShares MSCI Emerging Markets Index Fund ( EEM) and pouring into the Vanguard Emerging Markets ETF ( VWO).

These two instruments track the same index: the MSCI Emerging Market Index. At first, one would assume that comparing these funds would be akin to comparing apples to apples. However, if one delves deeper into the inner workings of the two funds, it becomes apparent why investors choose one over the other.

Although each of these funds seeks to track the performance of the same index, each does so differently. The EEM uses a sampling process, leading to the construction of a fund consisting of 439 of the more than 700 constituents in the MSCI Emerging Market Index.

VWO, on the other hand, tracks more than 800 positions, making it even more diverse than the index.

By tracking a sampled version of the index, EEM's performance at times will not always mimic the index.

Year to date through March 3, VWO's more comprehensive approach to tracking its index has paid off. Not only has the fund seen massive investor inflows, but it has managed to outperform EEM, which is down -2.1% compared with EEM's 3.3% drop. The MSCI Emerging Market Index is down 2.3% over the same period.

Seeing the success of VWO, it's no wonder that Vanguard has taken an important step to fix the tracking error issues facing its sector focused instruments while meeting the requirements of the IRS. The funds now track brand new underlying indices.

Rather than tracking the traditional versions of the MSCI indices, Vanguard's sector funds now track MSCI 25/50 indices, which meet the IRS requirements.

Though all of the company's sector-specific index funds and their respective mutual funds will take on these new indices, only a few are expected to see any significant weighting changes.

Aside from the VOX and VTCAX, the funds that will see the biggest changes due to the index alterations will be those tracking the MSCI US Investable Market Energy Index (which include the Vanguard Energy ETF ( VDE) and the Vanguard Energy Index Fund (VENAX)) and the funds backed by the MSCI US Investable Market Consumer Staples Index (which include the Vanguard Consumer Staples ETF ( VDC) and the Vanguard Consumer Staples Index Fund (VCSAX)).

John Bogle is Vanguard's founder and is known as the father of index mutual funds. He has long insisted that his firm take a shareholder-first approach, and the recent adjustments to the sector funds reflect this attitude.

By employing these new indices for its sector-specific funds, the company not only protects itself from breaking IRS rules; it also ensures that investors are provided with instruments that closely track their indices. In this case, both parties come out winners.

-- Written by Don Dion in Williamstown, Mass.
At the time of publication, Dion had no positions in securities mentioned.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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