I figured out how to add characters to Mugen.
Put your unzipped character files in $HOME/.paintown/mugen/yourcharactername/
You will need to restart PainTown. Mugen characters are only visible in Mugen.
There are plenty of mugen character download websites, here
is an example. Not all character files appear to be compatible with the gcw0 version.
And this just leaves one question. Can Steven Seagal beat himself?
It would be great if anyone feels like putting together a compatible set of themed characters eg DBZ, Marvel, Street Fighter, Mortal Kombat, etc.