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Beverly,

In your article Time to Sell Strong Funds?, you mentioned (and I have heard a lot of talk about this from other articles) that "market-timing" and turnover in mutual funds raises the costs to the fund and hurts performance. How can that be when all trading costs and expenses are built into the expense ratio? Would it not just cut into the fund's profitability as it relates to the fund company only?

-- J. Hanahan

We've received a number of questions regarding the specifics of market-timing and how it hurts funds. But before we get into a thorough explanation of market-timing, let's look at the issue of fund expenses.

A fund's expense ratio (which you can find in the fund's prospectus or on sites such as

Morningstar's) does

not

include all the fund's costs. A major omission from that figure is the fund's trading costs. When the fund manager buys and sells a security, he or she pays a commission on that trade. But while trading costs are not included in the expense ratio, they most certainly come out of the fund's total return -- they are subtracted directly from its assets, shrinking the fund's gain or deepening its loss.

In addition to the specific fees managers incur when trading, funds can also suffer market-impact costs. When a fund manager sells a big stake, it often causes the stock price to drop by essentially creating excess supply. That means that the stock price continues to drop as the fund continues to sell. A similar problem can happen on the buy side as well -- managers looking to purchase a large amount of a security can drive its price upward as they continue to buy.

In either scenario, the fund's shareholders lose as the underlying securities are either sold too low or bought too high. That's why most fund companies spread out their trades and buy or sell strategically. But when market-timers are entering and exiting a fund within days, the fund's trading staff may not have time to employ the best strategy. That's particularly true when the underlying securities are illiquid.

Frequent trading also leaves a wake of tax inefficiencies -- a burden only the remaining shareholders will be forced to carry.

Subsequently, market-timers can also force portfolio managers to keep more cash on hand to meet the frequent redemptions. Alternatively, it also can force managers to invest large sums of money quickly. Either way, the portfolio is managed to meet the needs of the market-timers as portfolio managers contend with the rapid inflows and outflows -- rather than managed more thoughtfully on behalf of longer-term investors.

Some Wall Street firms have made the argument that because market-timers move in and out of the fund so quickly, their money simply remains a part of the fund's cash holdings and never actually gets invested in the market. But the profit that the market-timers make -- even if their flows don't prompt the manager to buy and sell securities -- still has a dilutive effect on the fund's shares. It's common sense -- if the market-timers make a profit, that profit comes out of the fund's assets. That is, it comes out of the assets that remain once the market-timers have exited.

Market-timing is usually described as a form of arbitrage, wherein traders take advantage of inefficiencies in the way mutual fund prices are calculated. This strategy is particularly used in foreign funds, which hold stocks that trade on exchanges that open and close at different times.

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Here's how it works: A fund's net asset value, or NAV, is calculated once daily, at the market's 4 p.m. ET closing. The calculation is simple: The NAV is the current value of all the fund's investments divided by the number of fund shares.

So let's say a U.S. fund that invests in Asian stocks -- the U.S. Asia Stock Fund, we'll call it -- ends the trading day with assets of $100 million and 10 million shares outstanding, giving it a NAV of $10. Now, the next day, Asian stock prices decline 10%. The fund will also likely see its assets decline by 10%, giving it an NAV of $9.

But because the Asian exchanges close hours before the NAV is calculated on U.S. funds, there's an opening for some pricing inefficiency. Maybe

Sony

(SNE) - Get Sony Corp. Report

announces some good news during the U.S. market day -- after the Asian exchanges have closed.

A market-timer (say, a hedge fund or even an executive at a mutual fund company, as has been alleged in the cases of

Putnam

and

Strong

funds) can simply buy shares in the U.S. Asia Stock Fund at the $9 NAV, and then sell the following day when the prices pop.

So the trader spends $10 million to buy 1.11 million fund shares at $9 each. The next day, Asian stocks rise and the fund's assets swell 10% to $99 million, giving it an NAV of $9.90. The trader sells at this new NAV, and pockets $989,000 in profit. (That's 1.11 million shares sold at $9.90, less the $10 million spent to purchase them.)

The investors who stay in the fund, though, see the fund's assets drop to $98 million -- leaving them with an NAV of only $9.80, rather than the $9.90 the trader cashed out at. So the market-timing trader gets a big gain -- at the expense of the long-term investor.

Have a question for Bev on personal finance, tax or mutual fund matters? Write to her at beverly.goodman@thestreet.com.