We all know the importance of savings and how the smallest savings can help in achieving big life goals. Small savings made today can grow over time and create financial security, which can allow us to achieve our objectives. There are several investment options and instruments available in the market today to park small savings.
Investment instruments like mutual funds or chit funds let us make small investments in a phased manner to eventually accumulate a larger corpus in the long run. While both mutual funds and chit funds involve periodically pooling of funds from investors, they have different features and characteristics. Before selecting either of these to build an investment portfolio, investors must be aware of their unique benefits and risks. Here, we will explore these two concepts while trying to understand the key differences between them.
What is Chit Funds?
Chit fund is an old concept of savings and borrowings that was often used in the absence of bank facilities, especially by people in villages. By bringing borrowers and lenders together, chit funds helped individuals get a lump sum amount when they needed urgent funds for marriage, medical emergency, or business requirements. Chit funds go by many names like chitty or kuree, etc. In Chit funds, an individual enters into an agreement with a group of people such that all the parties can subscribe to a certain portion of the fund and receive it as periodical installments.
There is a draw, or auction held periodically. Once an investor’s name is called out, he/she can draw the amount required and continue to pay periodical installments as per agreed timelines. The remaining amount in the fund is distributed among all the other members of the fund.
A chit fund can be formed only after receiving prior approval from the state government. Chit funds are mostly limited to India. Some of the popular and successful chit fund houses in the country are:
- Mysore Sales International — Government of Karnataka
- Shriram Chits — Shriram Group
- Margadarsi Chits — Ramoji Rao Group
- Kerala State Financial Enterprise (KSFE) — Government of Kerala
How do chit funds work?
Let’s understand the mechanism of chit funds with the help of an example:
A group of 20 people pools Rs. 1,000 each on a monthly basis. Thus, in the first month, the total accumulated amount will be Rs. 1,000*20 = Rs. 20,000.
The accumulated amount will be put up for bidding and will be given to the person who offers the lowest bid. If Mr. A has quoted Rs. 10,000, Mr. B quotes Rs. 15,000 and Mr. C quotes Rs. 18,000, the lowest bid will be offered to Mr. A.
The chit fund organiser will charge a commission at 5-10% depending on the fund. This means he/she will charge at least Rs. 500 as commission on this transaction (Rs. 10,000*5%).
The balance in the fund, i.e., Rs. 20,000 – Rs. 10,000 = Rs. 10,000, will be equally divided among the 20 members of the fund. Thus, each individual will receive Rs. 500 per month. This process will continue until the end of the pre-decided fund tenure.
What are mutual funds and how do they work?
Mutual funds are investment vehicles in which investors can invest their money to get mutual fund units at the prevailing market value or NAV. These funds pool investor money to invest in various securities, as per the investment goals of the scheme.
Investors can invest in mutual funds through systematic investment plan (SIP) or lump sum investments. The Asset Management Company (AMC) is responsible for managing the funds pooled from investors. For investment selection and portfolio management, the AMC may hire a fund manager, depending on the fund category. The NAV of a mutual fund keeps changing as per prevailing market conditions and this can impact the return on investment for investors.
What are the key differences between a chit fund and a mutual fund?
Let’s have a look at some of the main differentiating factors between chit funds and mutual funds:
|Mutual Funds||Chit Funds|
|Saving and investment vehicles that help in capital growth through exposure to various capital market instruments.||Saving and borrowing tool that mainly allows accessibility to funds for those in need of finances.|
|Mutual funds follow sufficient transparency with regards to declaring financial performance as per SEBI guidelines.||There is a lack of transparency since chit fund organizers may not declare usage of funds as these are not regulated under any governing body.|
|Managed by professional fund managers appointed by AMCs.||Managed by chit fund houses that are mostly family run.|
|Fund house charges a small annual expense called expense ratio normally around 2% or 3%.||Chit fund organizers charge expenses at 5% or 10% that results in high cost of funds.|
|These are secure financial instruments since they are regulated by SEBI.||No assurance of security of funds as these are not governed by any governing body.|
|Investment is subject to market risks and returns may be impacted by market movements depending on the risk category of the fund.||These do not invest the pooled funds into any instruments and are therefore not subject to market risks.|
Which is better – mutual fund or chit funds?
Chit funds are known to carry the risk of the organisers misusing the funds and not paying back to investors. While some sections of society tend to benefit from these, it is better for risk-averse investors to stay away from such investments. If an investor wants to invest in these, it is ideal to pick a fund that is government-registered and has the required certifications.
Mutual funds, on the other hand, provide the right growth opportunity to investors, depending on the fund selected. Investors also have the option of making small investments through SIP or larger amounts through lump sum investment. Investors can also enjoy the benefits of transparency, especially when it comes to the risk-return profile of a fund.
Depending on individual preferences, an investor can invest in a chit fund or a mutual fund, or both. The choice between the two depends on financial requirements, investment goals, and investment capability of the investor. Both these investment options can yield profits if chosen and invested wisely. It is important to carry out thorough due diligence regarding each before making an investment.
- How can I invest in mutual funds?
To invest in mutual funds, you can download the Finity app on your smartphone. The app allows seamless access to a wide variety of funds. You can select a fund as per your investment time horizon and risk-return expectations.
- What is the advantage of chit funds?
Chit funds act as an investment and also allow access to funds. Investors can draw money from these depending on their needs while continuing to invest in them. The interest rate is fixed by the fund organisers and investors can earn comparatively higher rates.
- Are chit funds legal?
A Majority of the states and union territories in India have legalised chit funds. However, since these are not financial companies, they are not regulated by any governing body.
- Is chit fund money taxable?
Chit fund returns are considered as part of individual income and are therefore taxed as per applicable income tax rates.
- How many types of chits are there?
There are mainly five categories of chit funds, including registered, online, unregistered, organised, and special purpose funds.