Equities vs Chit Funds

        We did not know about the subject of Chit funds that well until a few clients of ours popped it to us. We were more piqued when one of them told us that his chit fund gives him a return of 18%. 

We were like 

EIGHTEEN PERCENT ?!? 

Why would anybody be doing any business but Chit Business if it can generate an 18% return? We mean WHY? We set out to dig deep to find it for our readers.  

Lets get started- For novices like us, let's get the basics answered first. 

What is a Chit Fund? 

As per Wikipedia - "A chit fund is a type of rotating savings and credit association system practiced in India.^[1] Chit fund schemes may be organized by financial institutions, or informally among friends, relatives, or neighbors..."

In simpler terms, Chit is a group of people who contribute a specified amount every month and create a common pool of Money. This pool of Money is then given to one of the members of the group as agreed. 

HOW CHIT FUNDS WORK

The investor pays an amount at specific intervals, usually a month, up to a fixed period. The money goes into a common fund. The amount collected is given to one person, usually selected in a lucky draw.

There is also the auction system for allotment in which the person who gets the money is selected on the basis of the lowest bid (he agrees to claim the least amount among the bidders). The difference between that and the full amount due is distributed among the other members. However, even after this, the winner has to continue investing.

Chit fund is a good savings instrument and it can be a reliable source of funds in an emergency.

One can also claim the amount without a draw through reverse auctioning. In this, the person who submits the highest bid (interest for picking the collected amount) is given the total collected money and his bid amount is distributed among the remaining people in his chit fund. This system is used in The Money Club mobile app which is a platform where people can form their own chit fund within their own trusted network (friends, family or office colleagues). The trusted network ensures a minimum credit risk here.

FUND MATHS

In chit funds, the number of installments (months) is equal to the number of members.

Following the reverse auction as in The Money Club app, let's assume that 10 people decide to invest Rs 2,000 for 10 months. So, every month, the collection is Rs 20,000 (Rs 2000 x 10 members). Now, let's say two members are willing to bid for getting this amount in a given month. Mr A bids for Rs 1,700 while Mr B bids for Rs 1,800. This means Mr A is willing to pay Rs 1,700 as interest while Mr B is agreeing to pay Rs 1,800 as interest (in order to get Rs. 20,000 pool amount). So here, Mr. B will win the pool amount and net-net he will get Rs. 18,200 ( Rs. 20,000 - Rs. 1,800).

Mr. B’s interest of Rs. 1,800 is distributed among the remaining 9 of his group members, so each one will get Rs. 200 as returns on their investment. The winner (Mr. B) cannot bid the next time.

ADVANTAGE OF CHITS OVER OTHER FINANCIAL INTERMEDIARIES

1. It is a borrowing cum savings instrument.
2. The rate of borrowing is determined by the participants themselves and not by an external agency. Usually is low.
3. The intermediation cost is the lowest when compared to other instruments.
4. The process of intrinsic evaluation based on factors like Social Collateral etc. give a lead this Institution, over the formal Banking sector, as an Financial Inclusion Activist etc.

DISADVANTAGE OF CHITS

1. Chit-funds do not offer any pre-determined or fixed returns.
2. Chance for default by the person who borrowed money.
3. The Foreman who runs the chit scheme charges huge amount as commission expenses (sometimes in the range of 5-10% pa).