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For an unbanked semi-literate man, a chit fund is an easy way to raise money for daughter's wedding. For a small shop keeper, it means an easy savings instrument. For a housewife, it is a kitty party fund that also ensures financial discipline. But for a genuine investor, it may appear to be a Ponzi scheme. One of the traditional investment schemes in India, chit funds may mean different things to different people but they are also one of the most insecure channels of investment due to their very nature.
They work like a recurring deposit, combining the benefits of a loan scheme. They are operated by big business houses as well as smaller ones. Various state governments also run their own chit fund schemes. At present, chit funds, are regulated under the Chit Funds Act of 1982. Various state governments have also drafted chit fund regulation guidelines.
Working
Chit funds work with a simple investment pooling technique. As each scheme is announced, interested investors join it. Based on the scheme, members pool in a specified amount every month, called 'instalment'. The best part is that member can get the entire maturity amount from the first month onwards. This is usually done by a lottery. Once the member gets the money, his or her name is excluded in the next draw.
However, if there are members in need for urgent money, they can request for an auction rather than the the lottery. They make bid on the maturity amount. The one who quotes the lowest bid (from the pooled amount) gets the money. The amount he forgoes is distributed among all members, lessening their instalment burden.
The company (called foreman in technical terms) also takes a small commission out of the auction every month.
Illustration
If 20 members pool in Rs 2,000 every month, they will have a fund (maturity money) of Rs 40,000 every month. If the lowest bid in the first month is Rs 35,000, after taking Rs 2,000 as company's commission, the surplus of Rs 3,000 will be divided equally among the members. This will bring down the next month's net contribution required of each member by Rs 150 (Rs 3,000 divided among 20 members). So for the next month, all the members will have to pay Rs 1,850 only instead of Rs 2,000.
The lower the bid, the more beneficial it will be for the members, as they need to pay lesser amount next month. But on the other hand, a lower bid means a costly loan to the bidder, as he receives a lesser maturity amount. The advantage for the bidder, on the other hand, is that he gets the money as a quick loan and without any collateral. The chit fund participants thus see this as a win-win situation. If you don't bid for the money till the end, it works like a recurring deposit.
Before you join…
Like any schemes, chit funds have its positive and negative features. So before you take a call on putting your money in a chit fund, there are few things you need to know.
Registered firms: It is mandatory that companies offering chit fund investment schemes must be registered with the respective state governments. But, there are many small unregistered companies, who may advertise heavily or are operated by a known contact, who would aim to gain your confidence through their length of association. Look beyond these factors to objectively assess the company or scheme.
No fixed returns: They don't offer fixed returns like other deposit schemes. The returns of a chit fund depend on the reverse auctions taking place each month. If you are an investor looking for assured returns, it may be prudent to avoid chit fund investments.
Liquidity issues: You cannot liquidate your investment until the chit fund completes its cycle or unless you win a successful reverse auction. Many investors believe that chit funds are useful to raise funds in an emergency, but to get money when you wish you will have to lower your reverse auction bid, thereby reducing your financial corpus.
NRI participation: The RBI has recently allowed NRIs to invest in regulated chit funds. All NRIs can now invest in chit funds, provided the investment is done through a regular banking channel and accounts managed in India.
There is no upper limit on the amount of investment an NRI can make in chit funds.
Possible manipulations: Chances are finite that fraudsters may join chit fund schemes to bid and usurp the money they get in advance; thereafter, they may discontinue further payments. Members who are in financial crunch may also drop out, as it happens in the case of loan defaults. Such drop outs affect the scheme as a whole, sometimes to the extent that the company finds it difficult to even complete the scheme's cycle. All these would affect the investments of members.
The fine print: Investors need to be extra careful while joining a chit fund. They should check the whereabouts and backgrounds of the promoters and go through every aspect of the fine print before participating in the scheme.
Bidding rules: There are chances that some desperate members may drive the auctions to very low levels. But chit funds regulated by the government have been mandated to ensure that bids cannot be lesser than 70 per cent of the chit value. The maximum commission a foreman can charge per bidding is five per cent, under the Chit Funds Act 1982. Private chit funds are also expected to follow this.
Comparison with other financial products
Chit funds vs. fixed deposits: Fixed deposits (FDs) offer fixed returns and an option to liquidate your money at any time. You can also avail a loan on it. FDs are regulated by the RBI, and the investments up to Rs 1 lakh are insured by the Deposit Insurance and Credit Guarantee Corporation. Returns in chit funds depend upon the auctions and are not fixed. You can avail the amount in advance as auction, but it is not guaranteed and based on the risk and the timing of your turn.
Chit funds vs. mutual funds: Mutual funds (MFs) link your investments with the equity or debt markets, depending on your fund. Both schemes have its own risks, but MFs are managed by experienced fund managers and your money is expected to be managed efficiently and professionally ensuring good returns. Chit fund investments depend on its members. You can redeem your MF investments at any time by paying an exit load (if required). But in a chit fund, you need to physically attend the monthly meeting to get information on the proceedings if you would like to avail the amount.
Chit funds can be chosen as an investment option depending upon your need and financial situation. But before investing in a chit fund, make sure that you are choosing a good company run by credible promoters. The state governments and the ministry of Corporate affairs publish a list of registered chit fund companies. It can be accessed at the official state government websites at http://www.mca.gov.in.
The writer is CEO, BankBazaar.com
