Turnover: Liquidity or Uncertainty?

The paper shows that turnover proxies for firm-specific uncertainty, not liquidity risk. I show that turnover is unrelated to several alternative measures of liquidity risk and that liquidity risk factors cannot explain why higher turnover predicts lower future returns. I show that, because high turnover firms have high uncertainty, high turnover firms beat the CAPM when aggregate volatility increases. All else equal, when uncertainty and aggregate volatility increase in recessions, the risk of real options drops and the value of real options increases. This effect should be stronger for high uncertainty (high turnover) firms and firms with abundant real options. I find that the aggregate volatility risk factor explains why higher turnover predicts lower future returns. I also find that the negative relation between turnover and future returns is stronger for firms with high market-to-book, or bad credit rating, or high leverage, and these regularities are also explained by the aggregate volatility risk factor. JEL Classification: G12, G13, G32