By now, we all recognize the importance of saving and investing. Why let your money just sit idle in a bank account or a safe locker while you work tirelessly for it? Instead, why not put your money to work for you, letting it earn more money passively? Gone are the days when the only way to make money was through hard work and effort. Today, it's about working smart and investing even smarter. It’s easier to make money by investing it wisely than by labor alone.
Unless you've been living under a rock, you've likely heard of mutual funds and chit funds. But have you ever wondered what the difference between them is? Well, think of mutual funds as the cooler, more sophisticated cousin of chit funds.
But jokes aside, chit funds are a more traditional and unorganized form of investment, common in South Asia. Typically run by a financial organizer, chit funds involve pooling money from a group—often neighbors, friends, or family—who regularly contribute a fixed amount. This pooled money is then available for members to borrow, serving as both a savings and borrowing mechanism.
On the other hand, mutual funds pool money from many investors to buy a variety of investments, such as stocks, bonds, or other assets. Market and finance professionals, known as fund managers, decide which investments to buy and sell based on the fund's goals. Mutual funds offer diversification, professional management, and liquidity, making them a popular choice for individual investors.
CHIT FUNDS
Chit funds are a popular investment scheme, especially in South Asia. Here’s how they work:
An organizer gathers a group—typically friends, family, neighbors, or other contacts—to participate in a chit fund scheme. This organizer manages the group's activities, handles finances, and keeps records. For their efforts, the organizer receives a commission. Once the group is formed, members agree on a fixed sum they will contribute monthly to a common pool.
For example, suppose Mrs. T sets up a chit fund and gathers 20 people. They agree to contribute ₹1,000 each month, creating a total pool of ₹20,000 (20 x ₹1,000). Mrs. T then conducts an auction or draws lots to determine who will receive the lump sum that month. Let’s say the lump sum is ₹15,000. The winner receives this amount, and the remaining ₹5,000 is divided among the other members, minus the organizer’s commission—say ₹500. The remaining ₹4,500 is distributed equally among the other 19 members, with each receiving ₹237. The process repeats every month until each member has received the lump sum.
Chit funds offer a unique financial tool that combines saving and borrowing opportunities. On the borrowing side, subscribers can access a lump sum upfront, even before fully contributing their share, making it convenient for immediate needs. On the saving side, regular monthly contributions act as a forced savings plan. Over time, subscribers accumulate a significant sum and potentially benefit from any surpluses generated during the scheme.
In India, chit funds are regulated by the Chit Funds Act of 1982, which contains rules and regulations to protect the interests of both investors and organizers. Chit funds are especially popular in South Indian states, though some institutions operate in the West as well.
Here are some benefits and risks associated with chit funds:
Pros:
- Easy access to funds when needed.
- Allows both saving and borrowing in a single scheme.
- Easier to join compared to formal financial institutions.
- Often involves trusted groups, fostering a sense of community.
- Offers the possibility of higher returns for early bidders.
- Encourages regular savings among members.
Cons:
- Susceptible to fraud if not regulated or managed properly.
- Does not provide interest on savings, unlike fixed deposits.
- Payouts depend on the group's cycle, which may not align with urgent needs.
- Returns can be unpredictable and vary from month to month.
- Members must continue making contributions even after borrowing, which can be a burden.
- Typically not insured, increasing the risk for members.
MUTUAL FUNDS
Mutual funds, on the other hand, are a more conventional and modern investment option. Mutual funds pool money from investors and invest it in various assets, managed by professionals. This offers diversification and expert guidance, making them ideal for beginners.
Managed Expertise: Professionals research and choose investments for the fund, reducing the burden on individual investors.
Diversification: By holding a mix of assets, mutual funds spread out risk, protecting against single-stock losses.
Variety: Equity, debt, balanced, and sector-specific options cater to different goals and risk tolerances.
Mutual funds are a great way to start your investment journey, especially if you are a beginner. There’s no need to research individual stocks or bonds—the fund manager does that for you while you sip on your milkshake, lay back, and watch your money grow. Mutual funds also don’t require a high initial investment. You can start a SIP with as little as ₹500 a month. If that’s not your style, you can invest a lump sum and build your portfolio. Mutual funds offer a convenient, diversified, and professionally managed way for beginners to start investing.
Mutual funds come in various types to suit different needs:
1. Structure of Mutual Funds:
- Open-ended funds: Allow investors to buy or sell units at any time.
- Close-ended funds: Have a fixed capital and trade on exchanges with limited redemption.
-Interval funds: Permit transactions only at specific intervals.
2. Mutual Fund Asset Class:
- Equity funds: Invest in company shares, offering high returns but higher risk.
-Debt funds: Invest in fixed-income securities for stability and regular income.
-Hybrid funds: Balance debt and equity investments for risk management.
-Solution-oriented funds: Target specific goals like education or retirement savings.
3. Mutual Funds Based on Investment Goals:
-Growth funds: Aim for capital appreciation through high-performing stocks.
-Tax-saving Funds (ELSS): Qualify for tax deductions under Section 80C with a minimum three-year horizon.
-Liquidity-based funds**: Offer liquidity for short-term goals.
4. Mutual Funds Based on Risk Appetite:
-Low-risk funds: Provide low returns with minimal market risk.
-Medium-risk funds: Balanced between debt and equity for moderate returns.
-High-risk funds: Have high equity exposure with potential for high returns, but higher risk.
DIFFERENCES BETWEEN CHIT FUNDS AND MUTUAL FUNDS
| Aspect | Chit funds | Mutual funds |
| Definition | A rotating savings and credit association where members contribute and periodically receive funds. | A pooled investment vehicle managed by professional fund managers, investing in a diversified portfolio. |
| Participants | Members who contribute fixed sums into the pool and bid for the lump sum in an auction. | Investors who purchase units of the mutual fund scheme, pooling their money for investment. |
| Operation | Bidding process determines which member gets the lump sum in each cycle; remaining members get dividends. | Fund managers invest the pooled money into various securities, aiming to achieve the fund’s objectives. |
| Regulation | Governed by the Chit Funds Act, 1982, often less stringent regulation. | Strictly regulated by SEBI (Securities and Exchange Board of India), ensuring transparency and safety. |
| Risk Factors | Risk of default by members, potential fraud, and varying returns based on the auction outcome. | Subject to market risk, credit risk, and liquidity risk based on the market and fund performance. |
| Returns | Vary with each auction; potential for high returns if bidding is favorable. | Depend on market performance and investment strategy; can be predictable in debt funds. |
| Liquidity | Limited; members usually cannot withdraw until the end of the chit period. | High; investors can redeem units anytime (subject to exit load and market conditions). |
| Accessibility | More accessible to rural and semi-urban populations due to lower entry barriers and community trust. | More accessible to urban and financially literate populations due to required knowledge and higher entry points. |
| Advantages | Simplicity, community trust, forced savings, social benefits like networking and mutual support. | Professional management, diversification of investments, regulatory protection, and potential for higher returns. |
| Disadvantages | Higher risk of fraud, less regulatory oversight, variability in returns, and potential member defaults. | Market-linked volatility, requires a certain level of financial literacy to choose the right fund, possible management fees. |
IN CONCLUSION
While both chit funds and mutual funds share the term “fund” in their names, they operate on very different principles. As seen from the table above, while both involve pooling money for a common purpose, chit funds are more prone to scams, whereas mutual funds are heavily regulated by SEBI, making them a more secure and preferable option.
At the end of the day, all investments carry some level of risk. It’s up to you, the investor, to choose the one that suits your financial goals and risk tolerance. It’s always advisable to consult a financial advisor before making any investment decisions.
That brings us to the end of this article. Be sure to check out our other articles on Jiniversity. And as always—
Happy Investing!
Also Read: 9 Best Options to Get Get Funds For Stock Trading In India
