How to build your own British ISA today

The government is planning to introduce a British ISA in a bid to revive the London Stock Exchange, an endeavour which ultimately might not add a great deal of liquidity to the market, and which adds further complication to the ISA system. Time will tell.

Of course, savers don’t need to wait until the British ISA is launched to buy £5,000 of UK shares in an ISA wrapper. Many already do, and though UK funds have fallen out of favour in recent years, investment in individual UK stocks by DIY investors is still very common. In theory investors can invest all of their £20,000 ISA allowance into the UK stock market, but that’s putting a lot of eggs in one basket.

The big question is how much of your portfolio to allocate to the UK and there are broadly three approaches to determining your exposure: one passive, one active, and one patriotic. If you’re investing passively in line with global stock market benchmarks, then around 4% of your portfolio should be invested in UK stocks, in line with a global tracker fund. That’s not a huge amount and many income seekers in particular will want more.

An active approach is to manage how much money you have in each region, and a good starting point might be to hold 20% in each of the UK, US, Europe, Japan and Emerging Markets. You can then dial these proportions up and down depending on your confidence in each market.

The patriotic approach is just to bung everything in the UK. However, this tethers your fortunes entirely to those of the UK stock market, which would have meant missing out on big returns in recent years.

Over the past decade an investment into the UK stock market would have turned £10,000 into £16,469, compared to £31,207 from global shares (source: FE total return to 6 March 2024). That doesn’t tell us what future returns will look like of course, but it does highlight the danger of allocating all your money to just one region. Sentiment can lead you astray when investing, including a desire to favour the domestic stock market out of loyalty. It’s also questionable whether this loyalty is rewarded when some of the biggest companies in the market aren’t terribly British, such as Antofagasta, a mining company operating predominantly in Chile, or HSBC, a global bank which derives 80% of its profits from overseas.

Most popular UK funds, trusts and shares with DIY ISA investors

Below are the most popular UK funds, trusts and shares bought by AJ Bell’s DIY ISA investors over the past year. These are broadly based on the government’s proposed qualification criteria for the British ISA, though as presently formulated they are somewhat inconsistent and subject to consultation, so may well change.

Source: AJ Bell, 5 March 2023 to 5 March 2024

These holdings highlight some design challenges for the British ISA. One is the treatment of investment trusts. The government is currently proposing to include companies that are incorporated in the UK and listed on a recognised stock exchange. Investment trusts meet this criteria, even those which invest in overseas assets (as is the case for many listed above). However, the government also suggests that for collective investment vehicles, which includes investment trusts, there will be a minimum exposure to UK companies, proposed at 75%.

This would suggest investment trusts that invest in overseas assets would not qualify for a British ISA. This is a conflict that needs to be ironed out by the consultation process. On the one hand it would be odd to include a company like Chilean copper miner Antofagasta, who invests in predominantly overseas operations, but not an investment trust that follows suit, especially when investors in both pay UK stamp duty for the privilege of buying shares. On the other hand, it would be just as strange for a Japanese investment trust to qualify for a British ISA but not a Japanese unit trust. This is the investment trust paradox faced by the British ISA.

There is a similar problem in the bond fund market. It’s not entirely clear from the government’s consultation whether they intend for bond funds to be included in the British ISA, though they do propose to make individual corporate bonds and gilts eligible. (Bond funds are included in the table of most popular investments above). The inclusion of corporate bonds funds would also raise questions, seeing as these generally invest based on the currency the debt is issued in rather than the location of the borrower. This is further complicated by the ability to invest in debt issued in overseas currencies but hedged back to sterling.

Why buy UK stocks?

Investors aren’t likely to want to buy into the UK stock market on the basis of past performance. UK plc does have some attractive features though. The first is the market comes with a pretty cheap price tag. Stock valuations are low by historical standards, and this provides both a cushion against further falls, and potential upside if sentiment turns more positive.

The UK is also an attractive place for income seekers because of the high level of dividends paid by the market. The FTSE 100 is currently yielding 3.9% on a historic basis, with the potential for both capital and dividends to rise over time. UK equity income investment trusts can be particularly useful on this score because their ability to hold back dividends in the good years and pay out in the bad leads to a smoother income trajectory.

UK smaller companies are also worthy of a mention. Small cap managers are currently chomping at the bit over the opportunities they are seeing because of the low valuation placed on these companies. This is a more volatile area best suited to more adventurous investors who can take a long-term view, but over the last twenty years the average UK Smaller Companies fund has returned 360% compared to 239% from the typical UK equity fund*.

Five UK funds and trusts for this year’s ISA

As mentioned above, investors need to consider how much they should allocate to the UK and maintain a geographically diversified portfolio. Below are some suggestions for how UK investors can gain UK exposure.

City of London: This trust benefits from having had Job Curtis at the helm since 1991, with a focus on dividend growth and quality, largely from the large cap segment of the UK stock market. The trust is one of the AIC’s dividend heroes, having raised its income distribution since 1966, the last time England won the football World Cup.

Fidelity Special Values: Fund manager Alex Wright is a contrarian investor, looking for unloved or overlooked companies that are set to stage a recovery. This can be a higher risk approach, but the fund is well diversified with over 100 holdings, and invests across the market cap spectrum.

WS Amati UK Smaller Companies: Dr Paul Jourdan has been running this fund for over twenty years and the whole team is steeped in experience when it comes to small cap investing. They look for high quality companies with competitive advantages. They have an emphasis on the AIM market, but they can invest in stocks all the way up to the FTSE 250.

Man GLG Undervalued Assets: Run by Henry Dixon, this fund invests across the UK stock market in companies of all sizes, which the manager believes are undervalued. This leads it to be heavily skewed towards more cyclical areas of the market.

Vanguard FTSE 250 ETF: With an annual charge of just 0.1%, this ETF offers investors a cheap and cheerful way to gain exposure to the UK’s medium-sized companies, a segment of the UK stock market which has performed well historically, and has a more domestic economic focus than the big blue chips of the FTSE 100.

*Source: FE total return to 6 March 2024.