MORNINGSTAR RATES FUNDS — WORKS FOR THEM, TOO: REVIEWER EXPANDING FEE-PAID CUSTOM RESEARCH

Mutual fund appraiser Morningstar Inc. for years has chided companies for the escalating fees they charge investors.

But the Chicago-based firm hasn’t been above grabbing a few of those basis points by doing custom research projects and reports for the companies whose funds it assesses.

Morningstar is now establishing an Institutional Services Group to formalize this quiet but growing part of its business, raising questions inside and outside the firm about whether its objectivity — and its reputation among individual investors for trustworthiness — might be jeopardized as the unit grows.

Additionally, Morningstar, with $40 million in revenues last year, is looking to become bigger in the 401(k) arena. It helps plan sponsors and providers monitor mutual funds for performance, style consistency and expenses, and it’s beginning to help in educating participants — functions often performed by investment advisers, a key client base for Morningstar.

In time, Morningstar could even give clients input on fund selection, says Gary Silverman, until recently the firm’s marketing director and now its vice president of institutional services, a new position.

Morningstar has discreetly provided custom research to mutual-fund firms, brokerages and insurance companies for years on an ad hoc basis. The company’s entry into the 401(k) market is more recent — within the last three years.

Both businesses have grown to the point where it made sense to establish a group to oversee them, Mr. Silverman says, declining to discuss specific numbers. But he acknowledges that Morningstar delayed making the move as it struggled with concerns about public perceptions.

“(Working for institutional clients) blurs the lines some,” Mr. Silverman allows. “But we’re an information and analysis provider and a tool provider. We are not going to be a fund-company consultant. Period. End of sentence on that.”

‘white knight’ persona

Still, the heightened focus on institutional business gives Morningstar’s competitors some ammunition to challenge the “white knight” persona the firm has created in positioning itself as the champion of the small investor.

“Business realities often make people change their tune, as Morningstar has done in the past,” snipes A. Michael Lipper, president of Lipper Analytical Services Inc., a fund tracker and industry observer that has drawn past criticism from Morningstar for its customized fund-industry work. “This is consistent with Morningstar’s changing views depending on what business they are in, and it is not surprising.”

The 401(k) emphasis also could rankle financial advisers with 401(k) clients, most of whom monitor fund performance and educate participants, as Morningstar is doing. Many of those same advisers use Morningstar’s Principia software as a research tool to select funds for their retail clients.

“Frankly, it’s a little disturbing to me,” says Robert A. DiMeo, managing director at Chicago-based DiMeo Schneider & Associates LLC, an adviser to 401(k) plan sponsors and a Morningstar customer. “Would I rather not see Morningstar calling on my customers? Absolutely,” he says. “But we’ll deal with it.”

Mr. Silverman responds: “It’s not our intention to directly compete with the adviser market.”

Instead, he says, Morningstar will be dealing more with large plan sponsors, which typically aren’t served by investment advisers but rather by large mutual-fund companies like Fidelity Investments and T. Rowe Price Associates. Current Morningstar clients include Delta Air Lines and paper company Mead Corp. on the sponsor side and Fidelity on the provider side.

protecting a good name

As for Morningstar’s other institutional work, the bulk of that is custom research, typically data not included in the firm’s established products. The regular client base in this business line numbers about 150 today and is fairly evenly distributed among fund firms, brokerages and insurers, Mr. Silverman says.

Morningstar knows its reassurances and reputation won’t convince everybody, so it’s instituting a code of conduct for employees doing institutional work. For example, the firm won’t accept a project from clients that demand a specific outcome. Also, analysts will work on reports for only those companies whose funds they don’t track and assess.

“We’re not going to risk our brand name and franchise on even the appearance of impropriety,” Mr. Silverman assures.

These tensions are inevitable as the institutional business grows, says Stephen Savage, executive director of competitor Value Line’s Mutual Fund Survey. But Morningstar’s strategy makes business sense.

“You can’t continue to grow indefinitely focusing only on the investor,” he says. “To grow, you have to go into new markets. There’s a lot of opportunity in the institutional area.”