This paper analyzes the ability of trading activity to explain cross-sectional variation in expected stock returns. We depart from the previous literature in not taking for granted that turnover is solely a proxy for liquidity. Instead, we test the impact of trading activity on monthly stock returns, after controlling for the usual factors (firm size, book-to-market-ratio and momentum) and for illiquidity costs. We estimate illiquidity costs (price impact of a trade) using intraday data from 1993 to 2002 for a large sample of NYSE and Nasdaq stocks. The results for the entire sample period provide evidence that higher turnover rates are associated with lower future returns after controlling for these costs. We also find evidence that the effect of illiquidity costs is related to firm size. Yet, for large and glamour stocks, which are very liquid, the effect of trading activity is still statistically and economically significant. During the dot-com period of 1998-2000, we observe that the turnover e¤ect is highly volatile across months and it is not signi…cantly negative. These findings call into question the presumption that trading activity is solely a proxy for liquidity.

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