(Dow Jones) Indexing powerhouse Vanguard Group took a step that should help many of its sector funds cope with indexing's old nemesis-tracking error.

The bad news is that, while the change may eliminate some confusion about how the funds perform, it won't necessarily mean they do a better job mimicking the industries they target.

On Friday the Malvern, Pa., fund giant said its slate of sector mutual funds and their corresponding ETF share classes, which divide the overall U.S. stock market into 10 categories such as telecommunications, financials, energy and utilities, will no longer follow indexes that weight companies based purely on their stock market values. Instead they will target benchmarks that are more "investable," tweaked to make it easier for mutual funds and ETFs to reproduce their returns, while still complying with Internal Revenue Service rules that prevent the funds from becoming too concentrated in a small number of stocks.

While the IRS rules are complex, they essentially cap investment in a single security at 25% of a fund's total assets and limit the number of holdings that can amount to more than 5%, creating difficulties for funds designed around industries dominated by just a few large players.

For instance, AT&T, with a market value of $147 billion, amounts to 46% of the index previously followed by Vanguard Telecommunication Services Index Fund. Another big company, Verizon Communications Inc. with a market value of $82 billion, amounts to 26%.

But to comply with IRS rules, the Vangaurd fund allocates only about 19% of its assets to AT&T and 18% to Verizon. Accounting for that regulatory reality, AT&T and Verizon represent smaller portions of the new "investable" index. Each are about 23% of the new target.

Not all sector index funds face this problem. Vanguard says that although it is switching benchmarks for all 10 sector funds, currently only three of the "investable" benchmarks are different from market-weighted ones. Besides telecom, the other two are energy, dominated by ExxonMobil Corp., and consumer staples, with companies like Procter & Gamble Co. and Wal-Mart Stores Inc.

Still, when discrepancies do appear, they can have big implications for investors' returns.

In 2009 the Vanguard telecom fund returned 29.6% compared to a return of just 12.6% for its benchmark, largely because AT&T and Verizon posted only modest returns while smaller telecommunications companies rocketed ahead amid an historic bull market. While investors might have been happy the fund overshot, rather than undershot its target, the 17-percentage point miss raises questions about its effectiveness as an index fund.

There is no easy solution. The iShares Dow Jones U.S. Telecommunications Sector Index Fund, the telecom sector offering from Vanguard's rival iShares, already tracks a modified benchmark. It returned 26.2% in 2009, more or less in line with the result Vanguard produced. The Select Sector SPDRs, another line of sector ETFs, doesn't include a telecommunications fund at all and instead lumps companies like AT&T in with technology.

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