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The UK stock market is not in great shape. What is less clear is what might improve it. Ahead of next week’s Budget, speculation has re-emerged that the Chancellor is considering a Great British ISA as part of the answer. The idea has merit, but I think there are better ways to make the London market more attractive to both companies and investors. 

It’s easy to argue that something needs to be done. More than £40bn has been withdrawn from UK-focused funds in recent years. In large part that’s down to pension funds which have scaled back a big UK equity overweight, principally in favour of bonds. Another reason is the poor performance of UK shares over the years. These trends have led to depressed valuations, a decline in new listings and a tendency for too many promising British companies to be taken private before they have fulfilled their potential. 

The argument for introducing an ISA that incentivises UK investment is that it is a quick and easy first step towards levelling the playing field. The format being discussed is a new £5,000 allowance, on top of the existing £20,000, that would be restricted to investments in UK-listed companies. It is not an unusual idea. Other countries encourage domestic investors to back their home-grown market. 

It could build on and complement other measures such as the government’s Edinburgh Reforms, which are focused on promoting early-stage investment in unlisted science and technology start-ups. A more attractive listing environment for young private companies to stay and grow here in the UK would have significant knock-on benefits for the broader economy. 

Promoters of the Great British ISA suggest that it could direct up to £200bn into UK businesses over five years. They get to this figure via data from the Financial Conduct Authority which show that there are more than 8 million people who have investable assets of £10,000 held largely or entirely in cash. The assumption, unproven I’d say, is that many of them could be encouraged to invest the £5,000 maximum in the British ISA. I suspect there is a reason these people prefer cash and a new ISA limited to British shares is unlikely to be the catalyst for change. 

The idea of a Great British ISA was aired ahead of last year’s Autumn Statement. In the end nothing came of it, with the Chancellor instead opting for a simplification of the rules around opening multiple ISAs in any one tax year. Now, it seems the idea is back on the table. 

One of the reasons that UK investors don’t invest more in ISAs is the complexity of the current system. The changes announced last autumn are a step in the right direction, but further simplification would help. We all find ourselves managing a series of evolving financial objectives and it can be hard to know what mix of products can help us achieve our goals. Complexity is the enemy of confidence, and adding to the existing cocktail of cash, stocks and shares, innovative and lifetime ISAs may not be the answer. 

Combining cash and stocks and shares ISAs to make it easier to move backwards and forwards between the two would be a good first step. For one thing it would reduce the friction that means many people hold large cash balances for too long, missing out on the higher investment returns that the stock market offers. Two thirds of ISA accounts are still restricted to cash, a ratio that has changed little over the past 15 years. 

Perhaps the strongest argument against a Great British ISA is that it would encourage home bias, the tendency for investors to favour their domestic market. This is a global phenomenon but it’s a particular problem in the UK, where our stock market’s diminishing importance on the global stage has outpaced our willingness to adjust our portfolios. The UK market accounts for just 4% of the value of shares worldwide, down from 10% a decade ago. Despite that, the average balanced model portfolio has a 25% exposure to UK shares. 

Investors opt for local assets for a number of reasons. They assume they have more information about their home market. They view foreign assets as riskier. In the past, regulation and transaction costs have made overseas securities less attractive. None of these arguments makes much sense anymore. 

Reducing home bias usually improves performance and leads to smoother returns over time. It reduces risk. First it cuts a portfolio’s concentration, a particular issue in the UK, where the top ten companies account for around 40% of the market’s total capitalisation. This is twice as high as for the global market and significantly greater even than in the US, despite the dominance of the Magnificent Seven

Tilting your portfolio to the UK also creates sector and style risks. Around half the value of the FTSE All Share index is accounted for by just three sectors - financials, energy and consumer staples. The UK market is a big bet, too, on the value investment style and away from growth and momentum. Historically this has outperformed, more recently it has not.

A Great British ISA will be challenging to deliver in a way that achieves its objectives. There are other ways in which the government could raise potential returns for investors and at the same time support companies that are considering listing in the UK. It could remove or reduce the burden of stamp duty for equity transactions, putting us on a level footing with other markets. It might also consider reducing the tax rate for UK dividends, simplify capital gains tax or reintroduce indexation to encourage longer-term investing. That’s less eye-catching than a Great British ISA perhaps, but it might lead to a better outcome. 

This article was originally published in The Telegraph

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Please be aware that past performance is not a reliable guide indicator of future returns. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Tax treatment depends on individual circumstances and all tax rules may change in the future. Eligibility to invest into an ISA and the value of tax savings depends on personal circumstances and all tax rules may change. This information is based on our understanding of the proposed LISA rules which may be subject to change. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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