Funds of funds are under fire. Paid generous fees for picking hedge funds for their investors, their role has been questioned lately in the wake of the Bayou scandal.

American International Group's ( AIG) Hedge Fund Strategies Group, a $7 billion fund of funds, belongs to the big guns category, serving a handful of large institutional clients. Amid AIG's accounting issues, Robert Discolo, who heads this fund of funds group, is relatively sanguine on hedge funds, Asia and the future of the industry.

Discolo took the time to discuss the outlook for the industry and his strategy in an interview with TheStreet.com.

TheStreet.com: Hedge funds have not performed so well this year. What's your outlook on the industry?

Robert Discolo: We realize that performance has gone down when looking back at some years when returns were averaging in the high teens. There is a lot more money in hedge funds now. But I am generally optimistic. Hedge funds bring together the most talented people in the world. Hedge funds are a talent pool, not an asset class. The key factor both for hedge funds and funds of funds is to have the right people.

TSC: Some are attacking the business model of funds of hedge funds. Are the fees justified?

RD: Fees are justified when you pick the right funds and put them together the right way. There are approximately 8,000 to 9,000 funds to choose from. Funds of funds also deliver capacity access to a fund closed to new investors. In 2000, we invested in a new long/short hedge fund. We had been working with this manager for a number of years. In 2002, he had a bad year and half of his clients redeemed. But we knew he had made money for his former firms before, we had a long-term relationship with him and we stayed. In the following years, he was up 60%, 30%. Last year, he had a couple of redemptions and he offered us the capacity: 100% to AIG. "You were in first; you know me and you were loyal to me," he told us. That's how you get capacity.

TSC: Describe your investment philosophy.

RD: Our portfolio is diversified. We have had close to a zero correlation to bonds over the past 18 years. If you want pure market exposure and a 15% return, it's not us. A lot of funds of funds sold themselves as portfolio enhancers. But funds of funds are more like a diversifier. We follow the Markowitz portfolio theory. If we get competitive returns, competitive risk and low correlation, we buy it. Right now, many funds of funds are taking a lot of market exposure. We don't do that. Why pay high fees for beta?

TSC: What about your organization? What strategies do you run?

RD: We're a $7 billion fund of funds but half of the money is our own money. The other half is our clients' money. That's a major point that distinguishes us from our competitors. In fact, it is the first question we ask our hedge funds: "How much of your own money is invested?" And when I mean our own money, I mean it's not just AIG that invests, but it's our employee fund, it's my own money, it's my kid's education. We allocate approximately 30%-35% to equity long/short; 25%-35% to relative value strategies; 30%-35% to event-driven and 10%-15% in macro and commodity trading adviser. But we have 27 sub-strategies underneath those four groups. Macro, for instance, will include short-term traders, energy traders, mid-long-term trend followers and non-trend following managers.

TSC: What are the main lessons of Bayou?

RD: I'm shocked that people invested in it. We sent a letter to our investors to tell them that we never invested in it. I won't go into the details of why we rejected the fund. But look at the audit. We have an approved list of auditors and an approved list of fund administrators. At AIG, we have an investigative team, a Kroll-like firm, but it's internal. We're the largest insurance company in the world, so of course we have that type of investigative team handy. A lot of funds of funds put their clients' money in tiny hedge funds. When we invest in funds with less than $50 million under management (and we do), we use our own money. We see that as part of our research and development effort. We may put in small amounts to find up-and-coming talent and negotiate capacity early on.

TSC: What strategies do you like?

RD: Event-driven strategies, energy strategies have been working for us. We've outperformed in distressed. Long/short has been very good for us too. We're investing in activism. Activism falls between private equity and hedge fund and it's offering higher returns. But activism is very risky because you have concentrated positions and it's long-only, so you don't have much downside protection. We're testing it right now: a lot of our managers do it as part of their overall investment strategy. But as a pure activist, you can easily get burned.

TSC: What makes you nervous?

RD: We look across our managers and see cross-holdings. A lot of managers do the same thing. For example, in special situations in Europe, a lot of people are in the same names. In October, we saw a quick selloff as some people got nervous. I am not that worried because our managers have the best analysis. But when the other managers start selling all at the same time, the liquidity dries up, the stock drops and you're going to get squeezed a bit when your positions are marked to market.

TSC: You are bullish on Asia. Talk to us about it.

RD: Yes, we are in Asia. Asia is the next hot place as there are many inefficiencies there and it's less crowded than the U.S. or Europe and you can do more things. A few years ago, shorting was impossible in Korea; now it's possible. But it's expensive to be there. There are infrastructure costs. You need to speak the language. The best talents don't speak English there. You also need to travel. You've got to have the relationships. And with our offices in Tokyo, Hong Kong, Singapore, India, China and throughout Asia, we are well-positioned to tap into this market. We like Asian long/short stocks. There will be tons of winners and losers over there and money can be made because of this inefficiency. For example, a stock in the U.S. may have 30 analysts following it and a P/E of 25. In Asia, a similar stock will have five analysts and a 10 P/E. I'm in Asia every two months and we are building a strong hedge fund infrastructure there.

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