Things I Learned about Chit funds and Rural Savings

Don’t worry, I am not going to bore you about ‘Ponzi schemes’ like Sharada chits masquerading as ‘Chit funds’ :-). Instead, I want to talk about the real chit funds where group of like-minded people from the same community join their hands together for savings and borrowings. Investments in chit funds are very popular in southern states like TamilNadu, Andhra pradesh, and Karnataka. It is one of the important financial instrument in rural India (where people still hate to deal with arrogant bankers) and yet very few people understand it. Given the way chit funds are structured (See the Image below), it cannot declare about the returns an individual is likely to make in advance. Final returns varies depending upon the financial needs of all the participants. In contrast, most ponzi schemes (like Sharada scam, 1996 TN chit fund scam etc.) are deposit schemes that offer eye-popping interest rates, cash prizes, and gifts for deposits with the chit funds.

During my recent trip to India, I caught up with my friends and as usual talks veered towards savings and investment. Most of them invested in local chit funds and yet nobody have any clue about the returns it generates. Hence, out of curiosity i got data from couple of friend’s chit fund investment and attempted to put a number on it.

[Note: I have fascination for chit funds from very early age. My father would say that he met all his life obligations like his sister’s marriage, his marriage expenses, my grandpa’s medical emergencies, our education expenses were met solely through this type of monthly chit fund investment. He might have invested in some 40-50 chit funds in his lifetime. He used to take us to the community auction spot where group of 20 to 30 people used to gather, pool their money, and bid for it. In our small town, most people might have invested in atleast 2 chit funds at any one point of time].

How chit funds works?

R Thiyagarajan of Shriram group built a formidable chit fund business. Shriram chits was started in the year 1974 and currently it has an AUM of 13,500 crores serving around 22 lakhs customers in 4 states (TN, AP, KN, and MH). In the newly released book, he noted the uniqueness of the chits and its role in the financial inclusion of rural household.

“Indian psyche is attuned to the concept of saving money. Every household and every individual want to save money and at the same time is also nervous if his savings will be adequate to meet his needs. Where will he go if he is unable to have his needs met? The chit somehow gives him an impression that as he saves, he also has protection.

The advantage in the chit business for a person who has been a member is that he has the right to take the money. The only concern is whether he is able to offer enough discount, so he doesn’t have to depend on anybody’s willingness to help him. It is his right and it preserves his self-respect to a large extent. So the peculiarity of this instrument, of its being able to be a saving instrument and double as a lending instrument means he doesn’t have to go about requesting the chit fund company to lend him the money. In fact, he can go demand it. That makes him feel very comfortable.

These things should be understood and appreciated and the government should make some modifications in the regulation of the chit fund business. Chit funds as an instrument could play a very useful role in achieving the government and the community’s objective of enhancing financial inclusion”.

Real Life example #1:

This chit fund was run by local finance professional. It is very similar to the chits run by Shriram, Margadarasi chits etc.

Number of people: 20; Auction: Monthly; Number of months: 20; Investment: 25,000; Pot money: 5 lakhs (20*25,000); 5% commission: 25,000 (5% commission is like fund management fees which goes to the person who runs the chit. He shoulders all the responsibility for the chit money and its monthly collection). Auction starts at 4,75,000 (after 5% commission) and the person who bids the lowest get to take the money home. For example, in the 1st auction, Person A places lowest bid at 3,58,000. Hence the divisible money for the group members will be 4,75,000-3,58,000 = 1,17,000. It is shared among all the 20 members as interest/dividend (1,17,000/20 = 5,850). And the same process repeated for 20 months.

[Note: I filled-in best possible guess for the future auction in August and September 2016. In October, there will not be auction as last person standing will get to take 4.75 lakhs].

From savings perspective: If a person’s whole motive of investing in chit fund is savings, he will not bid in any of the auction and likely to take the final pot money of 4,75,000. To get this final corpus, he invested around 4,43,000 over the period of 20 months i.e. 22,150 per month on average. I didn’t want to complicate by feeding these monthly numbers into excel sheet and calculate IRR. Instead, i flipped and asked what else he could have done if he had not invested in chit funds. Recurring deposit is the only other option for the monthly investment. SBI and post office offers interest of around 7.5% quarterly compounded. 22,150 monthly investment for 20 months will fetch 4,73,250. Here, chit fund did slightly better. Returns worked out to be 8% compounded quarterly. [A little anecdote from my friend’s mom: She can’t do math and doesn’t have much needs apart from education expenses. Hence she never called any auction in her 25 years of chit fund investments and will always take the final pot money].

From lending perspective: Most people invest in chit funds in anticipation of future funding needs. It can be education fees, business funding needs, or unanticipated medical emergencies. Recurring deposits will allow to withdraw only 90% of the corpus you invested so far. On the other hand, in chit funds you can borrow against your future payments which were agreed at the start. If a person calls money in any of the first 3-4 auctions, the interest rate works out to be around 24-25% which is roughly the same most credit cards charges i.e. he gets around 3.6-3.75 lakhs and pays back 4.43 lakhs (22,150 per month over 20 months as EMI). Most people avoid them unless they are in emergency situations. From 5th to 8th auctions, interest rate will work out to be 15-18% and so on.

Chit funds flexibility: 

Amazing feature of the chit funds is its flexibility nature. It can be both lending and savings instrument at the same time. Also you can tweak the rules in the way you want. In the above example, chit fund was run by a finance professional whose whole job is gathering people, taking risk, and running chit funds. In the local community, sometime people will run the chit fund for the lower commission structure (say 2%, 2.5% or 3%) or sometime without any commission at all (see the example below). Also, there can be weekly, bi-weekly, monthly, once in 3 months kind of chit funds. Sometimes, people run chit fund in the name of god and spend all the money collected as commission (5%) for the community festival.

Real Life example #2:

This is local community chit fund in which another friend invested. Here the rules are little different and hence returns are better.

Number of people: 21; Auction: Once in 3 months; Number of months: 60 i.e. over 5 years; Investment: 10,000; Pot money: 2.1 lakhs (21*10,000).

It has 2 important tweaks:

1. Commission is Nil. However, as the chit fund runs for 5 years, there is a real chance that someone might die/fall into a situation where they cannot continue further. Hence in the first meeting, everyone will pool 10,000 and save that pot of money (2.1 lakhs) for future unanticipated emergencies. Real auction starts from the 2nd installment [I was really amazed at this risk mitigation step!!].
2. If a person calls an auction, he is no longer eligible for the dividend/interest from the divisible money (i.e. pooled money – Auction value). Hence with each auction, number of participants decreases for divisible money. This ensures steady dividend/interest throughout the chit lifecycle and hence the returns are higher as seen below. [In the earlier example, people who called auction, are barred only from future auctions but eligible for the dividends/interest from divisible money].

As the chit fund runs without commission, returns are better. Also borrowings also works out 3-4% less than the example#1. In the example#1, the risk is borne by finance guy whereas in the example#2, the risk is borne by the community.

Key learnings for me:

1. People in tier-2/tier-3 towns are already sensitized to variable returns. Hence it is a myth that people don’t invest in equity mutual funds due to the uncertainty in the future returns. Rather the problem lies in the sales team who push the MF product at wrong time with unrealistic return expectation.
2. Most people in rural India intuitively understands that lower the commission, better the deal. However, due to the muddled thinking of our regulators, MF players fleece investors with high expense ratio of 2.5-3%.
3. Instead of looking down this financial product, people need to recognize chit fund flexibility as savings & lending instrument and the role it plays rural savings culture.

To be clear, am not advocating that people should go out and invest in chit funds. In fact, chit fund culture it is not present in many states. Also there is problem with unscrupulous players who may flee with the corpus. In fact, it is better not to invest in chit funds unless you have strong bond with the community and you are familiar with the counter-party you are dealing with.

Following is the suggestion i gave to my friends during the trip: I did not want to confuse them with asset allocation and re-balancing stuff. Typically, Debt allocation were met by mandatory employee provident fund/contributory provident fund. Short-term funding needs will be met by the local community chit funds which gives debt mutual fund like returns. Gold allocation will be met by the gold that comes with marriage. Hence i insist them on mutual funds (specially ELSS with 80C benefits) only for the retirement corpus and ask them not to touch for next 20-25 years.

Please let me know if i had made any mistake in the excel calculations. Looking forward to your thoughts 🙂