Dilution

'Dilution' Costs to Shareholders

Could Be Large and the Target

Of Regulators' Recovery Efforts

How much is the mutual-fund scandal going to cost mutual-fund companies?

Before it's all over, the bottom lines of mutual-fund companies could be in for some larger hits than are widely expected at this point. One reason is that investigators are focusing on how much "dilution" shareholders suffered in their fund holdings as a result of the short-term trading. That figure could end up totaling many hundreds of millions of dollars -- money that regulators are likely to try and take out of the coffers of mutual-fund companies.

For now, with investigations into abuses involving the trading of fund shares still far from complete, it is impossible to put a price tag on the biggest scandal to hit the fund industry in decades. A first stab at estimating the cost for just one company was taken by Bank of America last week, which said it was setting aside $100 million to pay for legal fees and other scandal-related expenses, as well as an undisclosed amount in restitution for fund shareholders

Janus Capital Group, another fund group mentioned prominently in the scandal investigation by New York Attorney General Eliot Spitzer, also has given an early figure on at least some of its expected costs. The firm pledged to pay fund investors all the management fees it earned on the money from rapid-trading hedge funds, a figure that Wall Street analysts peg at about $1 million.

Even so, add it up and the damage to mutual-fund companies from the share-trading scandal so far has been largely contained to tarnished reputations and a few lost jobs. Individuals have been indicted or pleaded guilty to wrongdoing, but no mutual-fund company has been charged with a crime nor paid any fines. Indeed, much of the attention on the expenses stemming from the alleged trading abuses -- such as higher trading commissions and costs linked to disrupting the management of portfolios -- involve figures that aren't particularly large for an industry that generates fees from overseeing $7 trillion in total fund assets.

Of course, there are other costs to the firms ensnared in the scandal, most notably the impact of fund redemptions by investors. Janus, along with funds run by Bank of America, Bank One and Strong Capital Management -- all of which were mentioned in Mr. Spitzer's complaint -- suffered investor withdrawals in September totaling $7.9 billion, or about 1.85% of their total assets, according to Lipper Inc. And in the case of Janus, there is also the battering inflicted on the company's stock, which has fallen just over 21% since the investigation was unveiled Sept. 3.

But dilution is likely to be the primary issue when it comes to reimbursing shareholders. It is a complex and unfamiliar term to most investors, but it boils down to a simple notion: The profit made by short-term traders of mutual-fund shares known as market timers is often money lost by long-term shareholders. Because money placed in a fund by a short-term trader was often just held as part of the portfolio's cash holdings and never invested in the market, there's a very close correlation between the market-timer's profits and the precise amount of money skimmed out of shareholder's accounts, investigators say.

"The fund companies take the position that there were no transactions costs since the timers did it all out of the cash holdings and there was no disruption," says David D. Brown IV, an assistant attorney general in New York involved in the state's fund investigation. "But if a timer goes in and out of a fund in a day or two and makes a million dollars, where's that money coming from? In that case his profits can be exactly equal to the dilution."

That notion has supporters among academics and some fund-industry leaders. "Even if the portfolio manager says they are not being disrupted, there is going to be the dilution," says Paul Haaga, chairman of the Investment Company Institute, the industry's main trade group, and an executive vice president at Capital Research & Management, which oversees the American Funds group.

The trading in question is a rapid-fire form of buying and selling of mutual funds known as market timing . These timing trades seek to take advantage of short-term dislocations between the price of a mutual fund's shares and the value of its underlying securities. Market timers often focused on international funds because the prices on the stocks held by those funds are generally hours out of date when funds set their share price at 4 p.m. Eastern time and would typically own only a few funds for a few days.

Here's an explanation prepared in 1997 by the Securities and Exchange Commission illustrating how dilution