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: 

Final Word

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