After much caution, the asset management industry at large is moving toward online advice, and early adopters have found success.

Measured by assets, Vanguard and Schwab are the biggest players in digital wealth, while BlackRock has become a leading institutional supplier of robo advice technology to banks and advisory firms.

But there's plenty of reason to be critical of how the asset management industry's embrace of digital has developed, says Matt Fellowes, former HelloWallet founder and CEO, who is launching a new digital retirement savings management platform, United Income.

United Income CEO Matt Fellowes says asset managers must prepare for a full transition to a digital-first market. Dan Nelken

Fellowes, who was also chief innovation officer at Morningstar, sees a number of issues among asset managers that need to be addressed in order for them to make a transition to a digital-first market.

He outlined several steps incumbents will have to take in an interview with Money Management Executive.

An edited transcript of the conversation follows.

Can incumbent firms simply add a digital platform / aspect to their business, or do they need to reorient their business entirely to a digital future?
I think it depends on the incumbent firm. As the flight to passive and fee compression continues, all firms face increasing pressure to maintain margins. Digital advice could be used as one powerful tool to do that, since it has the potential to replace — partially or entirely — higher-cost humans with lower-cost technology.

Firms with weak financials will be the most willing to take risks on re-orienting their entire business around a lower-cost digital offering, which will include a high level of automation of tasks humans currently perform. Firms with healthier income sheets or valuation trends will face less pressure and will likely continue to move more incrementally toward a digital future.

Is the digital space different than what the asset management industry has operated in? Are there similarities that can help ease a transition?
I think a big part of the problem with digital advice so far is that it is basically identical to the asset management industry that it is trying to disrupt, which makes it so easy for the industry to swat off these upstarts and avoid meaningful innovation. In fact, every digital solution we've looked at relies on some variant of the same formula used by Financial Engines 15 years ago: take a defined lineup of funds, a risk preference from the client, run some Monte Carlo simulations, plot an efficient frontier, and then select the "personalized" portfolio allocation across the lineup. Most of them also like to cite poor old Harry Markowitz to claim they have a Nobel winning approach, or something like that.

That is basically what home offices or third-party vendors, like Morningstar, currently do for advisers. Similarly, asset managers have had different products to manage different goals, even if they have not marketed themselves as 'goal-based' planners. That means the primary difference between the startups in the digital advice space and incumbents does not have a lot to do with technology or methodology differences. Instead, the differences are largely about marketing and distribution, since it is relying more on an application instead of a person. That is one reason why adoption of this functionality by incumbents has been so swift.

What needs to change inside an incumbent firm, from an operational perspective, to be competitive in a digital-first industry?
It really is dependent on the firm, but the five critical components will be increasing technical literacy, additions to the leadership team, creating new budget, implementing new organizational designs, and, most importantly, creating a higher tolerance for destabilizing ideas.

Technical literacy at some firms right now is just rhetorical: full of buzzwords like "AI" and "big data," but lacking in substance and coherence. Similarly, some firms have out-of-date technology leadership, partly because the teams have been worn thin by years of being distracted by the business-driven need to duct tape disparate technology stacks together.

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“Organizations will need to reorganize around digital services like technology companies do, rather than by distribution channels, which asset management has done.”

Leadership teams at incumbent firms often include technology executives, but business decisions are still largely made at some major firms by leaders who were former sales professionals or analysts. For these firms to fulfill their goals, they we will need to reverse their focus to also attract senior technology leaders who can then learn the asset management market, rather than the other way around.

New budget is surprisingly hard to come by at even the most well run companies because of the pressure on quarterly results. Given that, this transition at some firms will require Board-level attention and buy-in among the company's lead investors. Goldman and Capital One both offer good examples of this type of leadership.

In some cases, organizations will also need to re-organize around digital services like technology companies do, rather than by distribution channels, which asset management has done. Finally, firms need to adapt their cultures to create more of a forum for big, destabilizing ideas to be discussed and worked on. I am still surprised by the disconnect between the vigor of a marketing campaign at some firms and the lifelessness of their internal innovation process.

How difficult are these operational changes to make in light of the fact that many incumbents have legacy technology, internal culture or compliance concerns to deal with?
I think each firm will eventually need to assess the opportunity cost associated with not making these changes, which will give them confidence in their current path or the ammunition they need to make a case for change to their Boards and investors. For most firms, they can hold on for a long time by making the type of incremental changes we have seen so far, like quickly standing up a digital advice solution on a separate stack using technology that is at least 15 years old and methodologies that are decades old in some cases.

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Charles Schwab's robo is a good example of this and they deserve a lot of credit for moving so effectively to stand-up a quick test and learn solution. In many ways, it is a model of good incumbent leadership in a digital world because they got to market very quickly and then swiftly routed assets to their solution so they can test and learn before they embark on a bigger set of innovations. That type of incremental and swift experimentation will create the internal and external buy-in necessary to proactively pursue the future, rather than to be forced into it.

On the other hand, some firms already have that internal support marshaled and have the resources to acquire their way into the future. That can work very well and be transformational for a company when companies are thoughtful about how to effectively integrate new teams and technologies — Google's acquisition of a young YouTube or Adobe's acquisition of Omniture come to mind, for instance. And, if you're not familiar with that later story, just have a look at their stock price since 2010.

Is there an operational shift required of fund firms, from product provider to service provider and distributor?
Open architecture expectations in the retirement market mean that some incumbents will survive by continuing to focus on product manufacturing, without having to face the difficulty of trying to disintermediate their service and distribution partners. But, in general, the winners of the future will be focused on service and distribution, since they own the buying decision. That is why we have seen some product providers acquire or build their own solution in recent years. I would expect to see more of that activity in the years to come.

Who are you hiring? Is it a different roster than what you would see at an incumbent asset manager?
We've focused primarily on hiring economists, mathematicians and engineers from algorithm-oriented companies like Amazon, Palantir, and Solar City, all of which have experience working on parallel processing and other high computing functionality.

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“Internal innovation labs largely don’t work, since they become islands of creative thinking and can be too easily starved of financial and political support from the mainland.”

Since we've also invented a new approach to money management, which is heavily dependent on assessing the dependency of potential market and life outcomes in the future, we also recruited company advisers that have led the development and implementation of numerous laws and regulations governing the financial markets. That includes numerous people with no industry experience, like Howard Iams, who created the Social Security Administration model used to project benefits, and Erica Groshen, who was Commissioner of the Bureau of Labor Statistics and is an expert on consumer spending. That's absolutely a different roster than you'd see at incumbents, many of whom have struggled to attract tech top talent and have - in my mind - a dangerously outdated adversarial relationship with policymakers.

Several asset managers have R&D labs or venture capital arms. What innovation works inside an incumbent?
As the head of innovation at Morningstar, I met with dozens of firms, talked to a broad number of academics, and read a lot of literature on corporate innovation. The short answer is that it is not easy for incumbents to innovate, but it can be done.

From my experience, internal innovation labs largely don't work, since they become islands of creative thinking and can be too easily starved of financial and political support from the mainland. Corporate venture returns are better than standalone venture returns, which would suggest they can work. But, they must be strategic tools used by business leaders rather than stand-alone units — in other words, do not try to emulate Google Ventures like some have tried to do.

I've found Columbia's Rita McGrath or Innosight's Scott Anthony (a Clayton Christensen disciple) to be some of the most well-informed and helpful thinkers in this space. I particularly like the Growth Factory concept, or of dividing businesses into three units segmented by activities that are new to the world, new to the company, and new to the business line. Managed well, IBM's experience in the mid-20th century showed that this segmented business approach can work well at inspiring breakthrough ideas and technology.

A simpler way to get started, though, is with the Lean concepts. In that regard, incumbents like Charles Schwab have shown how to begin innovating effectively. They have a separate digital advice experience that is basic and focused, which they can learn from before embarking on a more expensive and fundamental innovation agenda.

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Suleman Din

Suleman Din

Suleman Din is technology editor of American Banker and Financial Planning. Follow him on Twitter at @sulemandn.