Chit Funds vs. Mutual Funds: All You Need to Know
There are a number of financial instruments in the market that enable people to save and invest their money. Chit funds have existed in India for a very long period of time. In simpler words, this instrument allows several people to pool in funds over a certain time frame.
A mutual fund is an investment instrument where a pool of stocks and/or bonds is managed by investment professionals of an asset management company. Investors can put in their money in different types of mutual fund units depending upon their risk appetite and duration of investment.
Let us explore some crucial information related to chit funds vs mutual funds.
What Are Mutual Funds and How Do They Work?
According to AMFI (Association of Mutual Funds in India), a mutual fund is a pool of money managed by fund managers who have the required knowledge and expertise. .
The money accumulated gets invested depending upon the fund’s theme. For instance, large-cap mutual funds will invest in stocks of large-cap companies. In addition, mutual fund managers can invest in both stocks and debt instruments. The returns generated by the fund are proportionately distributed among its investors after calculating the NAV (Net Asset Value) and deducting necessary expenses..
Let us understand this with an example. Suppose an individual invests in a mutual fund. Then, the fund house will allocate units depending upon the fund’s NAV. So, if you have invested Rs. 4,000 in a fund for which the NAV is Rs. 40, the number of mutual fund units you will receive from the AMC (Asset Management Company) will be 100.
What Are Chit Funds and How Do They Work?
Chit funds are financial instruments that people use both for savings and borrowing. It is primarily a rotating scheme that people, especially the residents of rural and semi-urban areas use in place of banking facilities.
Chit funds have been a part of the financial system in our country for a very long time now. It can generate good returns when investors use it as a savings instrument. In addition, people can rely on chit funds in case they face financial emergencies.
In a chit fund, a group of people get together and make periodic contributions for a time frame equal to that of the number of members. The date when the chit fund would commence is decided well in advance as the number of months has to be equal to the number of investors. Then, a person is selected via an auction or lottery system.
Let us understand this with the help of an example. Suppose a group of 10 people decide to contribute Rs. 2,000 each every month for 10 months. So, the accumulated amount in the first month would be (Rs. 2,000 x 10) which is Rs. 20,000. This amount will be put up for auction. Note that the person who bids the lowest will receive the amount. Suppose Arun quotes Rs. 13,500, Suresh quotes Rs. 18,500, and Kartik quotes Rs. 19,000. Arun, who has made the lowest bid, will receive the requisite money.
This is referred to as a reverse auction. The amount the winner forgoes will be distributed equally among the other members after deducting other necessary charges. The amount that each member thus receives is known as a dividend. Please note that the member who has won the auction and has claimed the amount must also keep investing for the remaining time period. Same activity is conducted each month until each and every member gets to bid.
Benefits of Investing in Mutual Funds
Listed below are the advantages of mutual fund investments:
- Considering that the fund houses follow SEBI’s guidelines and disclose their performances, investors can be sure of complete transparency.
- Mutual fund investments are convenient for all kinds of investors. This is because investors can deposit a lump sum of their investment money or deposit it periodically via the SIP investment mode.
- In addition, if you invest in mutual funds, you can be sure that there will be a lot of growth opportunities for your money.
- Mutual funds invest in various types of securities and thus offer the benefit of diversification. By investing across asset classes and market capitalisation, they mitigate losses due to market volatility.
- They offer the expertise of fund managers, who can take care of the challenges associated with market-related investments on investors’ behalf. Their experience and resources make it possible to find the right investment and entry/exit timings.
Benefits of Investing in Chit Funds
Given below are the benefits of investing in chit funds:
- Unlike formal financial institutions, people can borrow a lump sum amount without providing any documentation or collateral.
- Chit funds help to develop and promote a habit of savings among people at the very basic societal level. This is because every investor is supposed to contribute a fixed amount at regular intervals.
- Financially backward communities and people working in the informal sectors find chit funds a more convenient savings option. This is because it is difficult for them to obtain a loan from a financial institution without collateral and necessary documentation.
- Chit funds as a financial product that offer versatility because people can use them both for investments and as a borrowing tool. For example, when a person deposits a fixed amount every month, it is an investment. However, when the investor wins an auction, he can borrow money against subsequent instalments or future savings.
Limitations of Investing in Mutual Funds
Listed below are the disadvantages of mutual fund investments:
- Investors must consider the expense ratio before investing into their chosen schemes. It is, basically, the cost of fund management. This is important for choosing funds because a high expense ratio corresponds to low returns. However, a higher expense ratio may not always guarantee a fund’s good performance.
- While portfolio diversification is a desirable feature capable of generating benefits, it can also dilute profits.
- Some AMCs (Asset Management Companies) charge high exit loads to discourage early withdrawals. This is the money that investors have to pay if they wish to exit the fund before a stipulated date.
Limitations of Investing in Chit Funds
Listed below are the limitations of these schemes:
- Chit funds are associated with high transaction costs and are prone to many scams.
- Many unscrupulous people make promises of huge ROI (Returns on Investments), which they don’t fulfil. Often, investors fall for such promises as they lack financial literacy.
- Many people run unregistered chit funds, which are not regulated by law. As a result, organisers often misuse the pooled money as they cannot be held accountable.
- People who run unregistered chit funds are generally known to one another. As a result, organisers may expand the group without assessing the members’ creditworthiness.
- Registered chit groups need to deposit 100% of the chit value with the Registrar of Chits at the beginning of a chit scheme. After a chit life cycle ends, this amount gets refunded to these registered chit groups. However, many registered chit companies might run unregistered groups to avoid paying this particular amount. So, investors must ensure that the schemes they invest in adhere to the regulations.
- There always remains a risk of members defaulting on their payments if they have won auctions previously.
- Discount rates may be rigged in certain chit funds, so an investor who is desperate may end up paying a higher discount.
A Comparison Chart of Chit Fund Vs. Mutual Fund
The table given shows the differences between chit funds and mutual funds:
|Point of Difference||Chit Fund||Mutual Fund|
|Government Regulations||Registrar of Chits, appointed by the respective State Government, regulates chit funds as per Section 61 of the Chit Funds Act, 1982. Chit funds are Poorly regulated in many cases.||SEBI (Securities Exchange Board of India) regulates the mutual funds in India. These are Strictly regulated.|
|Purpose||These are primarily saving and borrowing financial instruments.||These are financial instruments for savings and investments.|
|Growth Opportunity||Chit funds are risky, but high-return investment options.||Mutual funds provide ample opportunities for your money to grow.|
|Taxation Rules||Chit fund returns are taxed under “income from other sources” as per the Income Tax Act.||Taxation depends on the type of the fund and the duration of investments. For example, equity and debt funds have different taxation rules for short and long terms.|
|Investment Period||The number of members determines the number of months. For example, if there are 7 members in a chit fund, the number of months in a chit group life cycle would be 7.||Investors can choose whether they wish to remain invested for a shorter, medium, or a longer term. Some AMCs charge exit loads upon early withdrawal.|
|Market Risks and Volatility||Chit funds are not exposed to the market, so they do not fall prey to market risks.||Mutual funds are market-linked products susceptible to volatility.|
|Expenses||Chit fund organisers levy a charge of 5% or more for their services.||Generally, AMCs charge up to 2.25% of the fund’s NAV for equity MF (1.75% for debt MF) as expense ratio. The average expense ratio ranges from 0.5% to 1% depending on the type of scheme invested in.|
|Rate of Returns||It varies from one chit fund to another.||Mutual fund returns depend on market performances and the fund managers’ strategies.|
|Liquidity||Investors must cite specific reasons, and if the organiser approves, they can withdraw their money early.||Mutual funds are associated with a high level of liquidity, as people can easily withdraw their funds by paying an exit load.|
People have always thought about the better option between chit funds vs mutual funds. This is because these savings options help people pool money over a fixed period. However, while SEBI has formulated rules for mutual funds, chit funds are more prone to scams. There have been cases of many unscrupulous people running unorganised schemes which do not come under the purview of the law.
Frequently Asked Questions
Are chit funds legal in India?
Many states and union territories in India have indeed made chit funds legal. However, people must remember that chit funds are not financial companies and are not regulated by SEBI. As a result, there is very minimal supervision by regulatory entities
How is the money gained from chit funds taxed?
The returns people earn from chit funds get added to their income and taxed as income from other sources as per the applicable income tax slab rate.
What are state-run chit funds?
Chit funds operated by the state governments are referred to as state-run chit funds. These funds offer minimum chances of loss. In addition, their business processes are transparent. Some examples of state-run chit funds are Kerala State Financial Enterprises (KSFE) and Mysore Sales International Limited (MSIL).