The Role of Limits to Arbitrage and the Asset Growth Anomaly*

In this paper, we hypothesize that if the negative relationship between asset growth and stock returns is due to mispricing, it should be more pronounced and more persistent when there are more severe limits to arbitrage. The empirical evidence supports our hypothesis. Our findings are not due to conventional risks, firm characteristics, equity issuance, idiosyncratic risk, or just a larger variation in asset growth. In addition, the role of limits to arbitrage in the asset growth anomaly is not a manifestation of liquidity risk and is not simply ex-post justified by trading expenses. Limits to arbitrage also plays a stronger role in the anomaly than the real-investments-with-frictions argument by Li and Zhang (2010). Our results appear to support the limits-to-arbitrage argument proposed by Shleifer and Vishny (1997)