<p>Sarita and her husband Shiva earn an income by working as a maid and a driver in my office. They invest a part of their income in the MahaLakshmi Chit fund that is run by a local jeweller. When the first meeting was called for the auction of the fund, Sarita and her husband did not participate and chose to wait for better returns. However, by the time Sarita was ready to bid, the jewellery shop was busted and the owners were caught by the police for fraudulent transactions. The police assured Sarita and other investors of the fund that their money would be returned; however, it has been over a year and they have still not received any news. And it is likely that they never will.<br><br>The story of chit fund investments going bust is nothing new. The Kolkata Saradha Group financial scandal is something that is still fresh in everyone's mind. Chit funds can enforce monthly investment discipline on small savers and can be crucial for financial inclusion. But unfortunately, chit funds are also used by fly-by night operators to defraud semi-literate investors.<br><br><strong>Chit Fund Basics</strong><br>A chit fund is a traditional savings and borrowing mechanism. Here, members pool in a specified amount every month and one of them gets the entire sum. This process is repeated every month till all members get the booty. The winning member is not chosen by a draw of lots, but through an auction. A chit fund means many things to many people. For some it's a personal loan, and others a recurring deposit. To people that are seeking a loan, it is a source of costly, but convenient, form of credit. Chit funds are indigenous saving mechanisms that is unorganised and run between friends, families and known persons. Chit funds are easy to join as there is very little paperwork to be submitted and the entire set up is based on trust. They have been around for over thousands of years and are present in other countries too where they are popularly known as Rotating Savings and Credit Associations. Take for example a group of 24 members who come together and contribute Rs. 3,000 every month for 24 months. The corpus will collect about Rs. 72000 in the first installment. Every month, an auction will be held in which the members are allowed to bid for the chit fund amount collected that month and the person offering the lowest bid will be awarded the bid. The bid will begin at a minimum discount of 5% (foreman fund or commission).<br><br><strong>Examples</strong><br>No of people in the chit : 24<br>Amount contributed per month: Rs. 3000<br>No of months to contribute: 24<br>Total corpus of chit fund per month: Rs. 72,000<br>Commission for front runner / agent: 5%<br>Commission for front runner / agent: Rs. 3,600<br>Net Fund Available for Bid: Rs 68,400<br><br>Take for example that the first bid goes for 35% discount or for 46,800. The discount amount of Rs. 25,200- minus the 5% commission to the foreman will be distributed as dividend amongst all the members. So, once the foreman is paid Rs. 3,600 as commission, the balance amount of Rs. 21600 is distributed among the 24 members and each member is entitled to get Rs. 900. Hence his net contribution will be Rs. 2100.<br>Here is another example:<br><br>Net fund available for Bid: Rs 68,400<br>Lowest Bid Amount: Rs 46,800<br>Net saving in First Bid: Rs. 21,600<br>No of People in Chit : 24<br>Each Member share: Rs. 900<br>Net Contribution: Rs. 2,100<br><br>The winner of the bid, also known as the "prized member" will have to continue contributing to the chit fund for all 24 months even though they are not allowed to bid again. The members who wait till the end for lower discounts will be the ones who really make a profit in the fund. The returns are not assured as it depends largely on the bidding interest.<br><br><strong>Popularity Factor</strong><br>Chit funds are one of the most popular investment vehicles in the country even though it is unregulated and the entire set up is built up on trust. Small businessmen and low income group individuals can avail funds on time at nominal rates through bids. Individuals who bid early in the chit funds do not earn any returns and end up paying an "effective" interest to avail the funds on an urgent basis. It is difficult to assess the profit or loss a person makes from chit funds as the outcome is largely dependent on the bid results. Often, persons who have bid early have been able to avail funds at lower rates than what they would have had to pay the bank on availing a loan.<br><br><strong>Regulation</strong><br>The Chit Fund Act, 1982, has been framed to regulate and control chit fund operation by various state governments, but unorganised chit funds are rampant in the country. Since the chit fund needs to deposit 100% value of the "pot" with the Registrar of Chits prior to commencement of the chit scheme, small funds do not register themselves as they will have to forgo the auction for the first month and the foreman will have to be paid the first month's fund to compensate him/her for the deposit made.<br><br><strong>Caution Alert</strong><br>Chit fund frauds have thrown up problems for various reasons, such as the foreman/fund manager disappears with the corpus amount. A member could default in installment payment or disappear after winning the first bid. The discount rate might be rigged and a desperate member might end up paying a higher discount. It is advisable to invest only in registered chit funds that have completed many chit fund issues in the past. The Ministry of Corporate Affairs has an exhaustive list of registered chit funds; however, many chit funds get unlisted, so do your research before investing. Secondly, only invest in a chit fund if you are confident that you will be able to complete all the installments or you might end up paying a penalty. Considering the risks, it is inadvisable to invest in chit funds, but if you intend to join one, do your homework thoroughly as there is very little scope of recovery in case of a scam. If you have access to opening a bank account and investing in FDs or taking loans from Banks, this should be the preferred option. If you don't bid for the money till the end, it is like a recurring deposit. You get your money back at the end of the chit's term. Though the sum received will be fixed, your returns will depend on the distributable surplus over the months. There is no assurance of return, nor a fixed formula for how much you can gain.<br><br><strong>Number Crunching</strong><br>Let's assume with the same example mentioned above with first bidding amount from Rs. 54,450 and the bidding amount increases Rs.600 every month. The person who waits till the end of 24 month pays Rs 64,956 over the entire tenure and gets Rs 68,400 in the end. The return works out to 5.7%, which is not very attractive when most banks are offering yields of up to 9% on recurring deposits. The bidding amount increases, since number of bidders reduces every month. The low returns from a chit fund are basically due to the very high commission that goes to the organiser. At 5% of the pool value, it is perhaps the second highest commission earned on any product after life insurance policies. Now you know why chit fund companies try to lure investors with freebies and gifts. If no commission was payable to the organiser of the chit, the return in the 24thmonth works out to 11.55%, which is superior than that offered by debt mutual funds. Additionally, the chit fund is an easy way to borrow, but the rate of interest is prohibitively high. Though no interest is charged, it is possible that the contribution keeps rising every month and the total outflow is more than that received. In our example, the member who bid in the first month received Rs 54,450, but had to pay Rs 64,956 over 24 months. The annualised interest rate works out to 20.09%.<br><br><strong>Weighing The Pros and Cons</strong><br>Chit funds provide both the flexibility to save as well as borrow and are like a compulsory savings tool which earns dividend every month. One gets finance/loan without much documentation which is very important for the lower income group, vendors etc who have no access to banks and institutions. Finance options through chit funds are easy to re-pay through remaining monthly installments. These investments are not affected by market fluctuations and are suitable for unorganized economy group or people unsure of their cash flows. On the flip side, one has to be very careful with regards to unregistered chit fund companies. Commission given to Chit Fund Organizer is too high which eats on the profits and there is no guarantee on fixed returns as these are based on auctions. There is a high degree of risk involved. Despite these shortcomings, investors flock to chit funds in large numbers. This is because the option offers tremendous flexibility to the member. He can treat it as a recurring deposit till he needs the money, just like an overdraft facility with a bank. Most people use chits to save for short-term goals, such as buying a vehicle or setting up a business. They are especially useful for goals that can crop up anytime during the tenure of the chit, such as a child's wedding or the purchase of a house. Even though the cost of borrowing is very high, because of the ease of transacting and funds are available without any surety or paperwork, people prefer these chit funds.<br><br><strong>Beyond Chit Funds</strong><br>If the same person needs the funds from bank or other financial intuition they ask for surety or mortgage or you have to go for a Gold loan which offers interest rate of 14% to 18% but you need to deposit your gold with them. With the government introducing the Jan DhanYojna account with the banks, this should transform the way those who did not have access to the main banking system to invest and borrow. The Pradhan Mantri Jan Dhan Yojna is a National Mission for Financial Inclusion to ensure access to financial services .Accounts can be opened in any bank branch with Zero balance.Fixed deposits are far more efficient and secure than Chit funds and this should be used more by many. And access to loans and better interest rates is also part of the scheme. Some Benefits under Jan DhanYojna include interest earned on deposits, accidental Insurance cover of Rs. 1 lakh, no minimum balance required, life insurance cover of Rs. 30,000 and access to pension, insurance products and loans with ease. This will surely be a great boon to many in India and will also help in understanding other investments options available rather than blindly trusting chit funds.<br><br><em>The author, Mimi Partha Sarthy, is MD, Sinhasi Consultants </em></p>
