Limits-to-Arbitrage, Investment Frictions, and the Asset Growth Anomaly

We empirically evaluate the predictions of the mispricing hypothesis with limits-to- arbitragesuggested by Shleifer and Vishny (1997) and the q-theory with investment frictions proposed by Li and Zhang (2010) on the negative relation between asset growth and average stock returns. We conduct cross-sectional regressionsof returnson assetgrowth on subsamples split by a given measure of limits-to- arbitrageor investment frictions. We show that: (i) proxies for limits-to- arbitrageand proxies for investment frictions are often highly correlated; (ii) the evidence based on equal-weighted returns shows significant support for both hypotheses, while the evidence from value-weighted returns is weaker; and (iii) in direct comparisons, each hypothesis is supported by a fair and similar amount of evidence.