Chit funds, a savings avenue that is as popular with housewives as it is with businessmen, have earned a bad name. The reason is the scores of scams in the name of chit funds, the latest being allegedly perpetrated by the Saradha Group in West Bengal.

Promoters put up a stern defence and say chit funds are the only financial product that gives people the option to both save and borrow, and the scams are giving them a reputation that is undeserved.

For instance, the Saradha Group fraud was perpetrated through a Ponzi scheme , though the group had named it chit fund to avoid scrutiny. In a Ponzi scheme, money from new investors is used to pay the old investors.

India has nearly 10,000 registered chit fund companies, the largest one being run by the Kerala government which has been in existence since 1969. Financial advisers also say that chit funds can be a good investment, provided the promoters follow the strict rules that have been laid down for them.

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.

One can also claim the amount without a draw through reverse auctioning. In this, subscribers come together for the auction. For instance, under the Kerala Chit Fund Act, the minimum prize money is 70% of the gross amount. Let's assume that the gross sum assured is Rs 50,000; 70% of it comes to Rs 35,000. If more than one person is willing to take this minimum sum, lots are conducted to select the winner. If no one is willing to take the minimum sum, a reverse auction is conducted, where subscribers bid for lower amounts; they start from Rs 50,000, Rs 49,000, Rs 48,000, and so on. The person bidding the lowest sum gets the money. Whatever money is accrued by way of discount is passed on to the remaining members after deducting the fee of promoters. There is no promoter fee in unregistered chit funds.

FUND MATHS

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

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 agrees to accept Rs 17,000 while Mr B bids for Rs 16,000. This means Mr A is willing to take a cut of Rs 3,000 while Mr B is agreeing to a Rs 4,000 discount (he, of course, will win the bid). If both bid the same amount, the winner will be selected in a lottery.

If the promoter charges Rs 1,000 for his services, Mr B can take Rs 15,000 (Rs 16,000 minus the organiser fee of Rs 1,000). The remaining Rs 4,000 (Rs 20,000-Rs 16,000) will be distributed among the members. The winner cannot bid the next time.

RISK INVOLVED

The biggest risk is misuse of pooled funds by promoters. The other is default by subscribers, affecting the promised fund distribution.

Various state and central laws regulate chit funds. The centre has the Chit Funds Act 1982. Remember that these laws govern only the registered chit funds. There is no redress if you fall prey to a fund that is not regulated.

"It is not advisable to invest in unregistered chit funds. Further, one should not put money in a chit fund whose other members are unknown to you. The key is investing in the right fund," says Adhil Shetty, chief executive officer, bankbazaar.com.

Hiren Dhakan, associate fund manager, Bonanza Portfolio, says, "The other risks are default by the promoter or if the promoter is running a Ponzi scheme in the garb of chit fund. One must invest only in chit funds which are well-known or managed by known promoters."

MONEY CIRCULATION

Organised chit fund schemes are required to register with the Registrar or Firms, Societies and Chits. Unlike in money circulation schemes, the subscription amount, tenor and drawable limit are fixed in chit funds. There are no incentives for subscribers to bring in more people to the scheme.

"Money circulation schemes work via a referral system, paving the way for frauds and schemes which cannot sustain themselves in the long run," says Shetty of bankbazaar.com.

SHOULD YOU INVEST?

It is not possible to calculate the exact returns as they depend upon the level of urgency of members (which decides the discount that they bid for and so the amount that will be distributed among the other members), which is highly variable.

"A chit fund is a good savings instrument for small investors and brings discipline in investments. It can be a reliable source of funds in an emergency. As chit funds are essentially not investment products, you must consider investing only if you see a need for funds in the near future that you may not be able to get from your bank," says Shetty.

Praveen PA, vice president-NBFC, JRG Fincorp, seconds Shetty. "It is a good product, especially where comparable institutional savings and loan products are not available. However, the credibility and creditworthiness of the company and its promoters should be a key consideration. One may opt for state-run chit companies and go with firms with a long record and financially sound promoters," he says.