This paper attempts to understand the role of turnover in the cross-section of the expected stock returns by theory analysis and emp irical test. A three-period model with short-sales constraints and heterogeneous beliefs shows there is a speculative bubble in equilibrium price; the bubble depends on the float (tradable shares of an asset), the investors’ risk-aversion and the trading cost; turnover is negatively correlated with expected return due to the speculative bubble in stock price. We then test the impact of turnover in monthly Chinese stock returns, after controlling for the usual factors (firm size, book-to-market ratio and momentum) and for illiquidity costs. The empirical method is Fama-MacBeth type regressions using risk adjusted returns on individual securities similar to the approach of Brennan, Chordia and Subrahmanyam (1998). We find turnover is one of highly robust determinants of the expected returns, and its effect on returns is stronger among the smaller float stocks. These empirical evidences are consistent with the predictions of the model.
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