(MONEY Magazine) – As you enter the nondescript offices of TIAA-CREF in midtown Manhattan, you could be in any corporate headquarters. Then you see the familiar face of Albert Einstein, haloed by frizzy white hair, flickering from a holographic image on the wall. The tag line appears: "Managing money for people with other things to think about." It's a not-so-subtle reminder that this company invests for the nation's smart set.

If you aren't familiar with TIAA-CREF, better catch up. Those eight initials are the familiar (and only slightly less awkward) way of referring to the Teachers Insurance and Annuity Association-College Retirement Equities Fund. For decades, this $280 billion outfit has managed retirement plans for college professors, hospital staffers and other nonprofit workers. (Einstein joined the plan back in 1933, when he taught at Princeton University's Institute for Advanced Studies.) Under the guidance of leading financial pros and academics, $90 billion CREF Stock, launched in 1952, has grown into one of the nation's largest private pension funds. Its complex stock-picking strategy has delivered stellar average annualized returns of 10.7% over that period, enabling thousands of absentminded professors and hard-working teachers to retire comfortably. An equally solid fixed-income annuity fund dates back to 1918.

In recent years, TIAA-CREF has expanded from the pension fund realm into the faster-moving retail market. Sticking to its low-cost, no-load roots, the company is now peddling such financial staples as term life insurance, annuities, 529 college savings plans and, starting in 1997, mutual funds. Even so, TIAA-CREF remains one of the largest but least understood money-management firms around.

We'll get to the unique investment strategy in a moment. But, first, we'll raise a question that some shareholders have been asking of late: If the managers at TIAA-CREF are so smart, how come their funds have performed so poorly this year? All three of the company's actively managed equity portfolios, which are essentially clones of its pension and college-savings funds, have lagged badly. (TIAA-CREF also offers an asset-allocation fund, two stock-index funds and five bond portfolios.) TIAA-CREF Growth Equity, a MONEY 100 fund, is down a steep 23.3% as of Nov. 16, three percentage points behind its benchmark, the Russell 3000 growth index. Similarly, TIAA-CREF Growth & Income, off 14.4%, is 1.5 percentage points behind the S&P 500. TIAA-CREF International Equity, which gave up 23.6%, lags the Morgan Stanley EAFE by nearly one point.

Hang on. For one thing, most stock fund managers have performed badly this year. And if you look at the past three years, TIAA-CREF's funds still beat their benchmarks. So you could quite reasonably let this year slide. But TIAA-CREF management won't. Famed chief investment officer Martin Leibowitz is quick to admit that fund managers simply picked too many bum stocks this year--among them losers like Lucent and EMC. Leibowitz, who joined TIAA-CREF in 1995, after 25 years as a fixed-income and asset-allocation guru at Salomon Bros., adds, "We are working hard to avoid future mistakes, and we remain committed to our strategy."

Now to explain that stock-picking process. Developed by CREF Stock pension managers and adopted in 1981, the method, known as the dual-investment management strategy, combines passive and active investing. The passsive portion of the portfolio follows an enhanced index approach. Using computer models, TIAA-CREF's quantitative team tries to exploit small, short-lived pricing blips to beat the fund's benchmark by a few basis points (hundredths of a percent).

For the actively managed portion, managers load up on companies that they consider undervalued. They look for strong cash flows, high returns on capital and low risks over the long term--typically five years or more. The managers adjust the proportions of the actively and passively managed parts of the fund, depending on market conditions. Instead of tapping a cash reserve to buy stocks, TIAA-CREF managers pull money from the passively managed part of the fund. When they see few opportunities, the managers boost the enhanced-index component. The actively managed portion can account for anywhere from 30% to 80% of the fund's assets but typically remains in the 40%- to-60% range. In stable or rising markets, the dual strategy has proved its value. "It allows the managers to focus on what they do best--pick stocks--without being forced to invest cash inflows or sell stocks to buy new ones," says Leibowitz. Adds Scott Evans, TIAA-CREF's director of equity investing: "Our strategy can earn returns averaging one or two percentage points above the market over the long term."

But when markets fall, the strategy offers little protection. The portfolios are always 100% invested. Unlike most stock funds, TIAA-CREF's lack a cash cushion that can limit losses in down markets.

Right now, TIAA-CREF fund managers, like so many others, are reviewing their losses and looking for the next opportunities. "We overstayed the party," admits Nancy Wadelton, who, along with Willard Wolff, runs TIAA-CREF Growth Equity. When large holdings in EMC and Veritas plunged, so did the portfolio. Of course, the managers also were handicapped by the fact that their benchmark, the Russell 3000 growth index, is full of tech stocks. In early 2001, its tech portion topped 50%. Recently, Wadelton and Wolff have been scooping up battered media stocks like Viacom and luxury retailers like Tiffany and Estee Lauder. "These are valuable franchises that have been hit hard," Wolff notes, "but they will come back."

Similarly, Carlton Martin, who runs TIAA-CREF Growth & Income, got caught when the fund's large stakes in telecom and wireless stocks, including Nokia and Lucent, plummeted. But his biggest mistake was underinvesting in the handful of tech winners. "Not having a large enough stake in Microsoft alone cost us a full percentage point in the second quarter," he says. "We now realize that it is better to be a bit more aggressive, holding fewer issues but with more conviction." After the market's post-Sept. 11 fall, Martin raised his actively managed portion to 60%, up from 40% earlier this year. Recently, the fund's biggest holdings included Nokia, Tyco and Home Depot.

At TIAA-CREF International Equity, the largest stake as of Sept. 30 was hard-hit Nokia, at 2%. And the fund was light on the better-performing drug and energy stocks. "We just couldn't find a lot of values in those sectors," says Christopher Semenuk, who co-manages the fund with Sachie Makishi. Even now, the fund is slightly overweighted in tech, sticking with Nokia, as well as German software company SAP and Dutch chipmaker ASML. And it has picked up a few defensive plays, including British tobacco maker BAT and Dutch consumer-products giant Unilever. But the actively managed part of the fund stands at just 41%.

The billion-dollar question, however, is whether any active fund manager, whatever the strategy, can consistently beat the index. A legion of financial pros and academics (including many participants in TIAA-CREF pension plans) argue that active managers can't outpace the market over the long run, chiefly because of management expenses and trading costs. But TIAA-CREF, interestingly enough, counts many diehard indexers among its fans, including indexing's most famous advocate, Vanguard founder John Bogle. "TIAA-CREF is 75% of the way there," says Bogle, who launched the first retail index fund. "At their cost level, they have a fighting chance to beat the index. There's a lot to like about the company."

We agree, and we think that TIAA-CREF has an excellent shot at delivering superior returns. Not just because of its sophisticated stock-picking methods--rather, the company's greatest strength is its overall attitude toward its shareholders. A nonprofit organization, TIAA-CREF places a premium on consistent performance, low costs and low portfolio turnover. "TIAA-CREF is a class act that has focused on delivering value to shareholders," says investment manager William Bernstein of Efficientfrontier.com.

So far, TIAA-CREF's retail funds remain largely undiscovered. Its 11 funds collectively hold just $2.8 billion. (It plans to launch five new funds in 2002, including a large-cap value fund, a small-cap offering and an index fund for real estate investment trusts.) But unlike many fund groups, which have been plagued by untimely redemptions in this wild market, TIAA-CREF has enjoyed net cash inflows this year, despite the performance slump. "A large percentage of our retail shareholders are also members of our pension plans," notes a spokesman, adding that many of these academics have continued to dollar-cost average during the down market. Another TIAA-CREF reminder that successful fund investing depends not just on smart managers but on smart shareholders too.

--PENELOPE WANG