If you’ve used Klein Decisions’ K⁴ Fund Selection, you’ve probably run into it: You reach the Results page of your scenario and three of the top 10 funds are different share classes of the same fund. In some instances it may be as many as four or five different versions of the same fund in the top 10. And it’s not just in the top 10, either; the same thing is happening throughout your fund rankings. 

The real downside to this is the fact that the actual fund ranks lose much of their meaning when multiple slots are taken by share classes of the same fund. For example, if the top three slots are filled by share classes of the same fund, the next fund will be number 4 rather than number 2 as it would be if you were truly looking at unique funds. This becomes even more of an issue as you move down the rankings.

Some users try to limit this problem by using filters requiring relatively low expenses. This is an attempt to eliminate share classes with high expense ratios or high 12b-1 fees, leaving only the cheapest classes of each. This can work, but it runs the risk of eliminating all of a fund’s share classes if the filters are set too low. While you might be happy to eliminate expensive funds, it’s important to remember that some (relatively) high expense funds also have stellar returns. You wouldn’t see them in your rankings if you used this approach.

A more direct means of limiting the number of share classes displayed in a scenario is by using the “Distinct Portfolio” filter. When it is used, all but one share class of each fund is eliminated and your scenario then ranks unique funds. That sounds good, but you need to be aware of how this is accomplished and the problems it can cause.

First of all, it’s important to understand how Distinct Portfolio determines which share class to illustrate. Since this is actually a Morningstar filter also available in the Principia and Workstation products, it works in a specific way. It doesn’t seek the share class with the best returns or the lowest expenses but rather the one with the longest track record. In many instances that will be an A or a B share, but probably not an institutional class or no-load version. Yet it’s those latter two that often carry the lowest expenses and the best returns. As a result, if you’re using returns and expenses as factors in your scenario – and many users do – the representative share class will not rank as highly as some of the younger classes would. In addition, the one appearing in your rankings may not be available to you (e.g., not included in your specific brokerage platforms, only available in qualified accounts, etc.) while the other classes might be. The bottom line is you may end up missing or underrating funds you would otherwise consider. This is often the case when a filter doesn’t work exactly as you think it should.

You can also add to the problem if you use additional filters. For example, if you use Distinct Portfolio along with a filter limiting expense ratios, you run the risk of completely eliminating a fund if its representative share class carries a high expense ratio. If this happens, you’ll never see any classes of this fund in your rankings even though one or more may pass your expense ratio filter and have a high preference ranking.

Does this mean you should never use the Distinct Portfolio filter? Absolutely not. As long as you realize what it is doing and the effects it can have, you can make adjustments in your review process to accommodate it. For example, it’s best to use Distinct Portfolio as a solo filter. That way you don’t run the risk of eliminating the surviving share class with your other filters. 

It’s also important to realize that specific share classes may rank higher than their representative Distinct Portfolio share class. For example, you may typically only consider the top 25 funds in a scenario. When using the Distinct Portfolio filter, the ABC Fund’s B share (its representative share class) may be number 29, so you normally wouldn’t consider it. But what about other classes? Because the B share is so close to your cutoff, you might want to see if any of the other classes fall within the top 25. 

An easy way to do this is to note the pre-filter rank of the 25^th ranked fund. Disable the filter and review all the funds up to that point. Yes, you’ll be back to seeing all the share classes of the same funds, but there’s a good chance one of ABC Fund’s share classes will show up before you work your way up to the 25^th fund in your post-filter rankings.  You’ll probably see some other funds worth considering, too - funds you’d have missed by only considering their representative Distinct Portfolio. While this procedure isn’t as quick and simple as just applying the Distinct Portfolio filter and relying on the results, it still limits the number of funds to be reviewed and should give you increased confidence that you considered all the best candidates.

Like any tool, the Distinct Portfolio filter has its limitations and must be used correctly. Once you’re aware of this, it can still be a valuable weapon in your arsenal: you just have to be careful how you use it.