Chit Funds vs Mutual Funds - What is Better for Investment?
Updated on September 10, 2024
Written by Manish Kothari
CEO Zfunds
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People are constantly looking for investment options that provide both growth as well as security. Chit funds and mutual funds are two popular investment options that offer distinct features and benefits. Hence, investors are often confused while opting for the best investment option for them. In case you are in the same situation, then you have landed on the right page! Here, we will delve into the two investment options and dive deep into what chit funds and mutual funds are, how they work, and ultimately, determine which is the better choice for investors. So, without any further ado, let us begin.
What is a Chit Fund?
Chit funds are traditional financial schemes that have been around in many cultures for centuries. They operate on the principle of pooling together money from a group of individuals, who contribute fixed amounts at regular intervals of time. The collected pool of funds is then disbursed to one member of the group through an auction or a predetermined system. Chit fund schemes often cater to individuals seeking short-term financial assistance or those looking to accumulate a lump sum over a specific period. Investors are now also looking for online chit fund schemes to invest their money.
How do Chit Funds Work?
While chit funds can have their own features, most of these have the same basic elements. These include:
Enrolment: Interested individuals join a chit fund by paying a specific amount as a subscription fee. There are chit funds that do not require participants to pay any joining or subscription fee.
Auction or Allotment: Every month, the members gather, and an auction is conducted where participants bid for the lump sum. In chit fund schemes, the highest bidders receive the amount and continue to contribute subsequently.
Disbursement: The process of auction/allotment and disbursement of funds repeats until every member receives their share of the collected pool.
What is a Mutual Fund?
Unlike chit funds, mutual fund schemes are investment options that are professionally managed and pool money from multiple investors and invest the same in diversified portfolios. There are several types of mutual fund schemes where individuals can invest their funds, such as equity funds, debt funds, hybrid funds, and more. These funds are handled by experienced fund managers who make investment decisions based on thorough market research and analysis.
How do Mutual Funds Work?
Here are the basic elements of a mutual fund or mutual fund investing:
Selection: Investors choose a mutual fund based on their investment goals, risk appetite, and return expectations.
Fund Management: The fund manager handles the investments, and tries to maximize returns by investing in a diversified portfolio.
Net Asset Value (NAV): The performance of a mutual fund is reflected in its Net Asset Value, which is the value of each unit of the fund.
Redemption: Investors can redeem their units at any time, subject to the NAV at the time of redemption.
What are the Major Differences between Chit Funds and Mutual Funds?
Following are the key differences between chit funds and mutual funds:
Regulation and Transparency: Mutual funds are regulated by financial authorities, ensuring transparency, adherence to guidelines, and investor protection. Chit funds, on the other hand, often lack strict regulation, making them prone to fraud and mismanagement.
Risk and Returns: Mutual funds offer a wide range of investment options catering to different risk appetites, whereas chit funds typically involve higher risk due to their decentralized nature.
Professional Management: Mutual funds are managed by experienced professionals, employing in-depth research and analysis techniques. Chit funds, however, rely on the collective decisions and participation of the members.
Liquidity: Mutual funds provide easy liquidity, allowing investors to buy or sell units at any time. Chit funds, however, have predetermined payout schedules and limited flexibility for premature withdrawals.
Flexibility and Diversification: Mutual funds offer investors the flexibility to choose from various fund categories and investment strategies. Chit funds primarily focus on providing lump sum payouts and may not offer diversification opportunities.
Mutual funds vs. Chit funds
| Aspect | Mutual Funds | Chit Funds |
| Definition | A professionally managed investment the money pool from investors to invest in various assets like stocks, bonds, and govt securities. | A savings scheme where a group of individuals contribute a fixed amount every month, and one participant receives the lump sum every month through bidding. |
| Purpose | Wealth creation through market-based investments over time. | A combination of saving and borrowing, depending on the participant’s need for their small term goal fulfilling. |
| Returns | Market-linked returns, which can fluctuate based on asset performance. Higher potential for growth but also higher risk. | The returns depend on the discount rate or the amount a participant bids during the chit auction. |
| Risk Level | Subject to market risks (stocks, bonds), so returns are not guaranteed. | Lower market risk but carries operational risks like default by participants. |
| Liquidity | Can be highly liquid depending on the type of mutual fund (e.g., liquid funds), but equity funds have expenses like expenses ratio and exit load. | Typically illiquid until the end of the chit cycle unless you win the bid early on. |
| Regulation | Regulated by SEBI (Securities and Exchange Board of India). | Regulated by the state-level Chit Fund Acts and monitored by the Registrar of Chits. |
| Transparency | High transparency due to stringent regulations and regular disclosures of NAV, portfolio, and fund performance. | Moderate transparency, as operations depend on the fund organizer's credibility, with fewer formal disclosures. |
| Investment Amount | Flexible, with no fixed amount. SIPs allow small monthly investments, and lump sum investments can vary greatly. | Fixed monthly contributions throughout the duration of the chit fund. |
| Lock-in Period | No mandatory lock-in period for most mutual funds, except for tax-saving (ELSS) funds with a 3-year lock-in. | The lock-in period lasts until the entire chit term is completed, usually ranging from 1 to 5 years. |
| Taxation | Returns are subject to capital gains tax. Equity funds have tax advantages if held for more than one year (LTCG), while debt funds have different tax treatments. | Not directly subject to capital gains tax; however, the chit amount received is considered income and taxed as per the individual’s tax slab. |
| Withdrawal | Partial or full withdrawal is possible anytime, depending on the fund type (exit load may apply). | You can only receive the full amount when you win the bid or at the end of the chit period. |
| Who Should Invest | Ideal for long-term investors looking for market-linked returns, capital growth, and diversification. | Suitable for individuals needing disciplined savings and access to periodic lump-sum funds, often for business or personal needs. |
| Professional Management | Managed by professional fund managers and analysts. | Managed by the chit fund company or organizer, with minimal professional oversight. |
| Return Predictability | Unpredictable due to market volatility; past performance does not guarantee future returns. | Returns are relatively predictable based on bid discounts but still subject to group dynamics and default risk. |
| Security | High, due to SEBI regulations and diversification across assets. | Moderate, subject to the reliability of the chit fund company and the group of subscribers. |
Both mutual funds and chit funds have unique benefits depending on the investor's needs, risk appetite, and financial goals.
Conclusion
In the battle between chit funds and mutual funds, the latter emerges as the better investment option for most individuals. With regulated management, diversified portfolios, and flexible liquidity, mutual funds offer investors a safer and more rewarding investment avenue. While chit funds have their place, particularly for short-term financial needs, investors should carefully consider the risks involved before opting for them. So, it's crucial to evaluate personal financial goals, risk tolerance, and investment horizon to make an informed choice between these two investment options.