What is the Difference Between Chit Funds vs Mutual Funds?
Among the popular investment schemes, chit funds and mutual funds have been significant saving sources for many Indians. In India, chit funds, also known as “chitragupta” or “kuri,” have been integral to the financial landscape for over 200 years. Rooted in small communities and cultures, they remain a means of credit for many and are regulated by chit-fund companies. Ivestors often compare them due to their similar functioning. Therefore, in this article, we will understand how chit funds and mutual funds work in a financial ecosystem and the significant differences between chit funds and mutual funds.
What are Chit Funds?
A chit fund is an investment scheme that was initially established to provide a means of credit to small traders and merchants who lacked access to traditional banking services. Thus, in this type of financial arrangement, a group of individuals contribute fixed chit amounts of money regularly into a common pool.
The participants, often referred to as subscribers or members, enter into an agreement with a chit-fund company or organiser to form a chit-fund group. A chit fund primarily aims to provide members with a savings and borrowing mechanism. The concept of chit funds was prevalent in other parts of the world too, such as Greece and Rome, where they were used to finance trade and maritime expeditions. Thus, with the advent of progress and awareness, people have started investing in government chit funds for safe trade.
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from multiple investors to invest in a diversified portfolio of securities. These securities may include stocks, bonds, and other assets such as equity, debt, and sector-specific investments. It is managed by professional fund managers who make investment decisions on behalf of the investors. The key advantage of mutual funds is diversification. Investors, also known as unit holders, purchase units of the mutual fund, representing their proportional ownership of the fund’s assets.
Chit Fund vs Mutual Fund
Let’s have a look at some of the differences between chit funds and mutual funds.
| Parameters | Chit Funds | Mutual Funds |
|---|---|---|
| Structure | Group of individuals contributing fixed amounts regularly into a common pool | The pool of money collected from multiple investors to invest in a diversified portfolio of securities |
| Objective | Savings and borrowing mechanism, facilitating access to funds and credit | Long-term wealth accumulation, capital appreciation, and achieving specific financial goals |
| Management | Typically managed by chit fund companies or organizers | Professionally managed by fund managers |
| Returns | Depends on the bidding process, with the potential for higher returns for the winner of the auction | Returns are linked to the performance of the underlying securities and market conditions |
| Risk | Relies on the reliability and integrity of the organizer and group members | Subject to market risks associated with the performance of the securities |
| Liquidity | Withdrawal before the tenure ends may not be easy or possible | Generally more liquid, allowing you to buy or sell units at the fund’s NAV on any business day. However, an exit load may be applicable on premature withdrawals in case of funds with a lock-in period. |
| Diversification | Limited diversification, as the funds depend on the contributions of a limited number of participants | Provides diversification by investing in a range of securities, spreading risk across asset classes |
| Regulatory Oversight | Varies by country and jurisdiction | Regulated by financial authorities (SEBI) and subject to compliance with regulatory requirements |
| Investment Duration | Fixed duration for each chit fund cycle, determined by the group | No fixed duration, investors can stay invested for the desired period |
| Investment Size | Contributions can be flexible, determined by the agreement among the members | You can start with small amounts and choose investment options based on financial capacity |
| Accessibility | Preferred by individuals with limited access to formal banking services | Accessible to individuals through various channels, including banks, financial institutions, and online platform |
How Do Chit Funds Work?
To understand how chit funds work, let us take a look at an example. Let’s say a chit fund investment group consists of 20 members. Furthermore, they decide to contribute Rs. 10,000 each per month. The chit fund cycle duration is set to 20 months.
In the first month, the total contribution to the chit funds schemes pool would be Rs. 2,00,000 (Rs. 10,000 x 20 members). The organizer conducts an auction or draws to determine which member will receive this amount.
For instance, Member A bids a discount of Rs. 5,000 on the total contribution, Member B bids a discount of Rs. 6,000, Member C bids a discount of Rs. 7,000, and so on. The lowest unique bidder, let’s say Member E, with a discount of Rs. 9,000, wins the auction.
Member E would then receive Rs. 1,91,000 (Rs. 2,00,000 – Rs. 9,000) as the payout, while the remaining Rs. 9,000 would be divided equally among the other members.
The process continues each month for the duration of the chit fund cycle. Each month, a different member would be selected as the winner of the auction until all members have received their turn to receive the lump sum payout.
How Do Mutual Funds Work?
Unlike chit funds, mutual funds pool money from different investors to invest in stocks rather than giving a lump sum amount to a specific investor. Thus, you are allocated mutual fund units through your preferred AMC (Asset Management Company). Subsequently, you may receive returns on your money invested in various stocks. All transactions are regulated by SEBI (Securities and Exchange Board of India), ensuring that your investment is secure and trustworthy.
What are the Popular Chit Funds in India?
Let’s have a look at some of the popular chit funds in India.
- Mysore Sales International – Government of Karnataka
- Kerala State Finance Enterprises – Government of Karnataka
- Shriram Chits – Shriram Group
- Margadarshi Chit Fund Private Limited – Ramoji Rao Group
What are the Types of Mutual Funds?
Here is a list of types of mutual funds that you must know about:
- Equity Funds: Invest in stocks and aim for capital appreciation over the long term.
- Debt Funds: Primarily invest in fixed-income securities like bonds and provide regular income.
- Balanced Funds: Maintain a mix of stocks and bonds to offer a balance between growth and income.
- Index Funds: Aim to replicate the performance of a specific market index, providing broad market exposure.
- Sector-Specific Funds: Concentrate investments in a particular industry or sector to capitalize on its growth potential.
What are the Types of Chit Funds?
The classification of chit funds may vary based on local laws and regulations in different jurisdictions. Thus, some of the general categories are mentioned below:
- Special Purpose Chit Funds: These chit fund schemes are formed with a specific objective in mind, such as funding a particular project or meeting a specific financial need. They cater to individuals who have a common purpose or goal and come together to pool their resources accordingly.
- Organized Chit Funds: Organized chit funds are professionally managed and regulated by chit fund companies or organizers. They operate within the legal framework and comply with the necessary rules and regulations set by the governing authorities, providing a structured and secure environment for participants.
- Online Chit Funds: With the advent of technology, online chit funds have emerged, enabling participants to engage in chit fund activities through digital platforms. These platforms facilitate the online management of chit fund operations, including contributions, auctions, and payouts, providing convenience and accessibility to participants.
- Registered Chit Funds: Registered funds are those that comply with the legal requirements and register with the relevant regulatory authorities. They offer transparency, accountability, and investor protection as they operate within the framework of the law, following specific guidelines and regulations.
- Unregistered Chit Funds: Unregistered funds, as the name suggests, do not comply with the regulatory requirements or register with the appropriate authorities. They operate outside the legal framework and may pose higher risks to participants, as they lack oversight and regulatory safeguards.
What are the Factors to Consider Before Investing in Chit Funds vs Mutual Funds?
Till now, we have covered some of the basics of chit funds and mutual funds. Now it’s time to review the factors that you may consider before investing in either of these two funds.
- Risk Tolerance: Consider your risk tolerance and comfort level with different types of investments. Mutual funds offer varying risk profiles based on their asset allocation. On the other hand, chit funds carry a different set of risks related to the reliability of the group members.
- Investment Goals: Determine your investment goals, whether they are long-term wealth accumulation, regular savings, or specific financial targets. Mutual funds provide opportunities for capital appreciation, while chit funds focus on savings and potential lump sum payouts.
- Time Horizon: Evaluate your investment time horizon. Long term investments can suit mutual funds more, as they enable the potential for compounded growth. Chit funds usually have a fixed tenure, and it’s important to align the tenure with your specific financial goals.
- Diversification Needs: Assess your diversification requirements. Mutual funds offer diversification by investing in a broad range of securities, spreading risk across various asset classes. Chit funds primarily rely on contributions from a limited number of participants. Consequently, this may not offer the same level of diversification.
- Professional Management vs Self-Management: Professionals manage mutual funds, making investment decisions on your behalf. Chit funds require active participation and decision-making from the group members themselves. Choose an option that aligns with your comfort level and available time for investment management.
Should You Invest in a Chit Fund or a Mutual Fund?
India has long been home to many chit funds. However, there have been instances where people have absconded with investors’ money, leaving no trace behind.
In some cases, chit funds have served as a last resort for people in urgent need of money, especially in areas where access to formal banking services is limited. These include small towns and villages, where banks and other financial institutions often overlook the financial needs of the population.
Despite several instances of fraud, chit funds remain prevalent in every corner of the country. This is primarily due to their ease of operation and the need they fulfill. According to Subba Rao Anupindi, a senior CA and financial planner, “Those who have other investments and savings options can avoid chit funds.
What are the Benefits and Challenges of Investing in Chit Funds?
Advantages of Investing in Chit Fund
Let’s explore the advantages of investing in chit funds:
- Easy Access to Funds: Unlike formal financial institutions, these funds allow individuals to borrow a lump sum without cumbersome documentation or collateral requirements.
- Promoting Savings Habits: Chit funds foster a savings culture at a grassroots level. This requires investors to contribute fixed amounts at regular intervals.
- Inclusivity for Informal Sectors: Financially disadvantaged communities and informal sector workers find these funds more convenient for savings. Consequently, overcoming the hurdles of collateral and documentation typically associated with traditional loans.
- Versatility as a Financial Tool: Chit funds serve both as an investment and a borrowing tool. Regular contributions constitute an investment, while winning auctions enables investors to borrow against future savings.
Disadvantages of Chit Funds
However, be cautious of the following limitations:
- High Transaction Costs and Scams: Chit funds have elevated transaction costs and susceptibility to scams, with deceitful promises of significant Returns on Investments (ROIs).
- Unregistered Chit Funds: Unregulated and unregistered funds are prone to misuse of pooled money, often leaving investors without recourse.
- Creditworthiness Oversights: Unregistered groups may expand without evaluating members’ creditworthiness, posing risks to the stability of the chit fund.
- Deposit Manipulation: Some registered chit companies might avoid depositing the full chit value with regulators, compromising investor protection. It is crucial to ensure adherence to regulations before investing.
- Default Risks: Members who have previously won auctions pose a potential risk of defaulting on their payments.
- Rigged Discount Rates: Certain funds may manipulate discount rates, potentially causing desperate investors to pay higher-than-necessary discounts.
What are the Benefits and Challenges of Investing in Mutual Funds?
Advantages of Investing in Mutual Funds
The following are a few benefits of Mutual Fund Investments:
- Ensure Transparency: Fund houses adhering to SEBI guidelines guarantee transparent operations.
- Convenient Investing: Mutual funds accommodate both lump sum and periodic investments through SIP.
- Capitalise on Growth Opportunities: Mutual fund investments promise ample avenues for your money to grow.
- Diversification Advantage: Mitigate market volatility by investing in various securities across asset classes and market capitalisation.
- Tap into Expertise: Leverage the skills of fund managers to navigate market challenges, ensuring optimal investment decisions and timings.
Challenges of Investing in Mutual Funds
Watch out for these Mutual Fund Investment challenges:
- Mind the Expense Ratio: Evaluate the cost of fund management, as a high expense ratio can lead to lower returns.
- Diversification Trade-Off: While beneficial, excessive portfolio diversification may dilute profits.
- Exit Load Considerations: Some Asset Management Companies may impose high exit loads for early withdrawals.
Which is the Better Option – Mutual Funds or Chit Funds?
SEBI regulates professionally managed investment vehicles known as mutual funds. In addition, mutual funds can deliver returns to all investors, unlike chit funds, which typically benefit only one individual at a time. However, for some people, chit funds may be a better option, especially for those who wish to acquire a lump sum amount by making a small initial payment.
With rising literacy rates, many people are increasingly inclined toward more structured investment options like the stock market, mutual funds, and others. However, the emotional connection between small towns and chit funds cannot be overlooked.
Thus, there is no definitive answer as to which is the better option: chit funds or mutual funds. Ultimately, the choice depends on your specific financial situation, investment goals, risk tolerance, and access to financial services. It is advisable to assess your needs, consult with a financial advisor, and weigh the pros and cons of each option before making an informed decision.
To Wrap It Up…
Despite their similar functioning, the difference between chit funds and mutual funds is quite apparent. Mutual funds, regulated by SEBI, offer diversification to reduce overall investment risk, while chit funds, being largely unregulated, are more prone to scams.
Therefore, it is advisable to consult a financial advisor before investing in chit funds or mutual funds. On an individual level, a key consideration should be the credibility and creditworthiness of the company and the fund’s promoters.
Frequently Asked Questions About Chit Funds and Mutual Funds
A mutual fund pools money from multiple investors to invest in a diversified portfolio of securities. Conversely, chit funds are savings schemes where a group of individuals contributes fixed amounts regularly and receives lump sums at regular intervals.
Yes. The Chit Funds Act of 1982 regulates the chit fund business in India. However, one must remember that financial institutions like SEBI do not govern or regulate these chit funds.
In contrast to chit funds, which are a great tool for borrowing and saving simultaneously, Systematic Investment Plans (SIPs) are merely investment avenues for mutual fund investments.
Mutual funds and chit funds have different return potentials. However, the group’s contributions and the bidding process influence the overall returns.
Chit funds aren’t a bad investment. It has a bad reputation due to its misuse in the past. You can invest in Government-run and registered chit funds that are safe.
Yes, you can invest in both mutual funds and chit funds. That is, if they align with your investment goals and risk tolerance.
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