Mutual Fund vs Chit Fund: Which Gives Better Returns?

Understanding the Basics: Mutual Funds and Chit Funds

Before we jump into the comparison, let’s clarify what Mutual Funds and Chit Funds are, how they work, and why they attract investors.

Mutual Funds are professionally managed investment vehicles that pool money from many investors to buy a diversified portfolio of stocks, bonds, or other securities. Investors typically invest through Systematic Investment Plans (SIPs), contributing a fixed amount regularly, which compounds over time.

Chit Funds

Scenario: Investing ₹20,000 Monthly for 3 Years

To illustrate the difference, imagine you invest ₹20,000 every month for 3 years (36 months). Let’s compare what happens if you put this money into:

• A Mutual Fund SIP with an average annual return of 12% (after expenses)
• A well-managed Chit Fund with monthly bidding and typical organizer commissions

This is a realistic scenario for many middle-class investors looking to grow their savings steadily.

Mutual Fund SIP Returns: The Power of Compounding

Mutual Funds grow primarily through compound interest — earning returns not only on your principal but also on accumulated earnings. Over time, this leads to exponential growth.

Using the formula for future value of a series of monthly investments:

 FV = P × [((1 + r/n)^(nt) - 1) / (r/n)] where: P = monthly investment (₹20,000) r = annual return rate (12% or 0.12) n = number of compounding periods per year (12) t = number of years (3) 

Plugging in the numbers:

• Monthly investment (P) = ₹20,000
• Annual return (r) = 12% = 0.12
• Compounding frequency (n) = 12 (monthly)
• Time (t) = 3 years

Calculating the future value (FV):

FV ≈ ₹8,33,000 (approximate)

Total invested amount = ₹20,000 × 36 = ₹7,20,000
Profit = ₹8,33,000 - ₹7,20,000 = ₹1,13,000 (approx)

After accounting for the expense ratio (typically 1-2%), the net profit hovers around ₹1.3 lakh as per common estimates.

Chit Fund Returns: The Bid Discount Advantage

Chit Funds operate differently. Every month, members contribute ₹20,000, but one member receives the pooled amount (₹20,000 × number of members) after deducting the bid discount and organizer’s commission.

The bid discount is the amount by which the winning bidder agrees to take less than the full pot. This discount is then distributed among the other members as a sort of return.

For example, in a 36-member chit fund, the monthly pot is ₹7,20,000. If the winning bid discount is 5%, that’s ₹36,000 deducted. After organizer’s commission (say 5% of the pot), the remaining discount is shared among non-winning members.

Over 3 years, each member gets a share of these bid discounts, effectively boosting returns beyond the nominal monthly contributions.

Result: Profit ≈ ₹1,67,000 (approximate)

This is significantly higher than the profit from the mutual fund SIP in this scenario.

Why Does the Chit Fund Outperform?

The key driver is the bid discount. Unlike mutual funds where returns depend on market performance, chit funds generate a return by redistributing the bid discount among members.

This mechanism creates an effective interest rate on your contributions, which can be surprisingly high if the chit fund is well-managed and bidding is competitive.

However, this comes with caveats:

• Liquidity Risk: You cannot withdraw your money anytime like a mutual fund SIP. You must wait for your turn in the chit cycle.
• Credit Risk: If members default on contributions, the fund’s health suffers.
• Regulatory Risk: Chit funds are regulated but less transparent than mutual funds.
• Organizer Risk: The trustworthiness of the chit fund organizer is crucial.

Comparing Returns, Risks, and Liquidity

Let’s look at a comparative table summarizing key aspects:

Real-World Example: Rajesh’s Investment Journey

Rajesh, a 30-year-old IT professional from Bangalore, wanted to invest ₹20,000 monthly for 3 years. He was torn between a mutual fund SIP and a chit fund recommended by a family friend.

After using the LoanVsFD app’s calculator and running the numbers, he found:

• Mutual Fund SIP would grow to about ₹8.33 lakh
• Chit Fund payout, factoring in bid discounts and commissions, would be around ₹8.87 lakh

Rajesh also considered liquidity needs. Since he needed access to funds for emergencies, he split his investment — ₹12,000 into SIPs and ₹8,000 into chit funds.

This hybrid approach balanced returns with flexibility.

The Hidden Costs and Risks of Chit Funds

While chit funds can offer attractive returns, it’s vital to understand the hidden costs:

• Organizer’s Commission: Typically 5% of the chit amount, reducing overall returns.
• Default Risk: If a member defaults, others must cover the shortfall or the fund collapses.
• Delayed Payments: Winning bidders sometimes delay payments, impacting the fund’s cash flow.
• Regulatory Oversight: Unlike SEBI-regulated mutual funds, chit funds have varied state regulations, sometimes leading to less investor protection.

Always verify the chit fund’s registration, track record, and organizer credibility before investing.

Mutual Funds: The Safer, More Transparent Choice

Mutual funds, especially those regulated by SEBI, offer:

• Professional fund management
• Diversification across sectors and asset classes
• Easy liquidity and exit options
• Regular disclosures and audits
• Systematic Investment Plans (SIPs) that encourage disciplined investing

However, market volatility means returns are not guaranteed. The 12% annual return is an average, and actual returns can fluctuate.

When Should You Consider Chit Funds?

Chit funds might be suitable if:

• You want a forced savings mechanism with a lump sum payout at some point.
• You trust the chit fund organizer and group members.
• You can lock in your money for the chit duration without needing liquidity.
• You want potentially higher returns than fixed deposits or some mutual funds.

They are often used in communities where informal credit access is limited.

When to Prefer Mutual Funds?

Mutual funds are better if:

• You seek professional management and diversification.
• You want the flexibility to exit investments anytime.
• You prefer regulated, transparent investment vehicles.
• You are investing for long-term goals like retirement or children’s education.

Impact of Inflation and Time Horizon

Inflation erodes the real value of money over time. Both chit funds and mutual funds must generate returns above inflation to create real wealth.

Mutual funds, especially equity-oriented ones, have historically beaten inflation over long periods. Chit funds’ returns depend on the bid discount and may or may not keep pace with inflation.

Longer investment horizons favor mutual funds due to compounding and market growth.

Visualizing Growth: SIP vs Chit Fund Over 3 Years

Below is a simple bar graph comparing total corpus after 3 years of investing ₹20,000 monthly:

Summary: What Should You Do?

• Chit funds can offer higher returns than mutual funds in the short term due to bid discounts.
• Mutual funds provide better liquidity, transparency, and diversification.
• Assess your risk tolerance, liquidity needs, and trust in the chit fund organizer before investing.
• Use calculators like the LoanVsFD app to simulate returns and compare options based on your inputs.
• Consider a balanced approach — combining chit funds for short-term lump sums and mutual funds for long-term growth.

Final Thoughts

Investment decisions should never be based solely on returns. Understanding the underlying risks, liquidity constraints, and your personal financial goals is crucial.

While chit funds might surprise you with higher returns, they come with risks that mutual funds typically mitigate through regulation and diversification.

Always do your due diligence, consult financial advisors if needed, and use trusted tools to guide your choices.

Ready to compare your options? Download the Loan versus Fixed Deposit App now for smarter financial decisions.