THIS MAY BE

one of those situations where the right thing to do is the wrong thing to do. Let me explain.

Suppose you own shares in a mutual fund, and you learn that the fund company that manages it has been fingered in the recent scandal over market timing and late trading. Should you immediately dump your fund shares?

First, I'm going to tell you all the reasons why that's exactly the wrong thing to do. And when I'm done, I'll then tell you why you should probably do it anyway. Oh and then I'll tell you whom you should blame for this mess.

Let's start by getting realistic about how hurt you are likely to have been by any market timing or late trading going on in your fund. To work through some examples, we'll assume that we are talking about a fund with $1 billion in assets. Among popular funds, that would be about midsized.

Suppose that the fund manager lets an unscrupulous hedge fund buy fund shares after the close on days when some great news moves the market higher after hours (when ordinary fund shareholders can no longer trade). To make it worth it for the hedge fund, the move would have to be substantial say 1%, which doesn't happen very often. Let's say that whenever it does happen, the hedge fund buys $20 million in fund shares, and then sells them the next day.

If the hedge-fund manager had not bought his shares after hours, the next morning the market would open 1% higher and the fund would appreciate by 1% on $1 billion, that's a $10 million gain for all the shareholders. But with the hedge fund's $20 million in cash now sitting in the fund, that $10 million gain has to be divided across a larger fund value. Instead of a 1% gain, it drops to a 0.98% gain.

In other words, every time the hedge-fund manager engages in late trading, it costs the fund two basis points in performance. How often does it actually happen? Maybe 10 times a year at most? Then that would be 20 basis points in a year. But wait it doesn't work every single time. Let's say out of 10 tries, it works seven times, breaks even twice, and downright fails once. That would mean the mutual fund's performance would be reduced by two basis points seven times for 14 basis points but improved by two basis points once, for a net performance loss of 12 basis points over a year.

Now let's look at market timing. Here the problem is that when certain shareholders buy and sell frequently, they may force the fund to hold more cash to give them ready liquidity (and to that extent keep the fund out of the market). Suppose the fund keeps an extra 1% cash. What would that really cost the fund? Historically, the stock market has gained about 10% a year, while cash balances have earned about 3.5% a year. If 1% of the fund in cash therefore sacrifices 10% performance for 3.5% performance, that's a performance drag of 6.5% of 1%, or six basis points a year.

Six basis points, 12 basis points this is nothing. If you love your fund because it has been giving you great performance, does it really make sense to switch to another fund that you don't love just because you suddenly learn that, without market timing or late trading, you could theoretically have earned six or 12 basis points more? That would seem to be throwing the baby out with the bath water.

And don't forget that selling your shares won't get you those six or 12 basis points back. They're gone forever.

And besides if the manager of your fund has been implicated in these scandals, you can be darn sure that there will never be any late trading or market timing in your fund ever again. So why sell now, just when you can be sure that the problem is solved?

Don't forget that selling your fund shares may not be free. If you hold the fund shares outside a tax-deferred IRA account or 401(k) plan, your sale could trigger capital-gains taxes. Is it worth it to pay those taxes now rather than years in the future when you really want to sell the fund for real investment reasons just because you're miffed about a slight performance drag that will almost surely never happen again anyway?

OK, you're probably saying, that's fine. But if market timing and late trading have been going on, doesn't that mean that your fund company is run by a bunch of crooks? Should you be letting such people manage your money?

Well, no, you shouldn't. But you need to be realistic about just how crooked your fund manager really was to do these things. As Alan Reynolds of the Cato Institute points out, neither market timing nor late trading are actually crimes in the usual go-to-jail sense of the word. Late trading violates a 1968 Securities and Exchange Commission regulation; market timing doesn't even do that.

Yes, these are moral lapses and regulatory infractions. Certainly late trading gives privileged investors an unfair advantage over you and me, and that's not right. And market timing possibly suggests that the fund manager doesn't have sufficient process controls in place. But to hear the extraordinarily harsh condemnations of the fund industry coming from the press and from New York State Attorney General Eliot Spitzer, you'd think your fund manager was holding a gun to your head and shouting "your fund shares or your life!" It's just not that way.

Have I convinced you that maybe you shouldn't dump your shares? Good. Now here's why maybe you should ignore everything I just said and dump them anyway.

It's simple: Because everyone else is panicking. With billions flowing out of the targeted fund companies, their funds are forced to dump shares of stocks they own. That runs up transaction costs that will be paid by the shareholders left in the fund. It depresses the prices of the stocks held in the fund. It may make fund fees go up, as the fund's fixed costs have to be spread across a smaller asset base. And in some circumstances, it may create significant tax burdens for the fund that you could end up paying if you stick around.

Sure, the right thing to do is to stick with your fund. But with everyone else dashing for the exits and the very fact that they're running up costs that you will have to pay if you don't dash right along with them who can afford to do the right thing?

It's not a pretty choice, is it?

Now what do you suppose got you into this fix where you have to make a choice like that? Surely the fund companies aren't blameless. But in my view the regulators have to take the greater share of responsibility here.

Why? Because they've handled these relatively small and isolated problems in a way that has exaggerated their importance and triggered an industrywide witch hunt, which in turn has triggered an entirely unwarranted investor panic.

The right way to handle this would have been to bring ordinary regulatory enforcement actions against the worst wrongdoers, and at the same time quietly put the industry on notice that a higher standard of compliance would be required in the future. That's the way mutual-fund regulation has evolved quite successfully over the last 63 years and there's absolutely no reason to arbitrarily change that now.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.