We investigate the role of information-based trading in affecting asset returns. We show in a rational expectation example how private information affects equilibrium asset returns. Using a market microstructure model, we derive a measure of the probability of information-based trading, and we estimate this measure using data for individual NYSE-listed stocks for 1983 to 1998. We then incorporate our estimates into a Fama and French~1992! asset-pricing framework. Our main result is that information does affect asset prices. A difference of 10 percentage points in the probability of information-based trading between two stocks leads to a difference in their expected returns of 2.5 percent per year.ASSET PRICING IS FUNDAMENTAL to our understanding of the wealth dynamics of an economy. This central importance has resulted in an extensive literature on asset pricing, much of it focusing on the economic factors that inf luence asset prices. Despite the fact that virtually all assets trade in markets, one set of factors not typically considered in asset-pricing models are the features of the markets in which the assets trade. Instead, the literature on asset pricing abstracts from the mechanics of asset price evolution, leaving unsettled the underlying question of how equilibrium prices are actually attained.Market microstructure, conversely, focuses on how the mechanics of the trading process affect the evolution of trading prices. A major focus of this extensive literature is on the process by which information is incorporated into prices. The microstructure literature provides structural models of how prices become efficient, as well as models of volatility, both issues clearly of importance for asset pricing. But of perhaps more importance, microstructure models pro-

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This paper uses volume arising from small trades to analyze the effect of retail investor trading behavior on the cross-section of stock returns. The central finding is that stocks with intense sell-initiated small-trade volume, measured over the past several months, outperform stocks with intense buy-initiated small-trade volume. This return difference accrues from the first month after the portfolio formation up to three years later. The results suggest that stocks favored by retail investors become overvalued and subsequently experience prolonged underperformance relative to stocks out of favor with retail investors.

We examine the potential profits of trading on a measure of private information (PIN) in a stock. A zero-investment portfolio that is size-neutral but long in high PIN stocks and short in low PIN stocks earns a significant abnormal return. The Fama-French, momentum, and liquidity factors do not explain this return. However, significant covariation in returns exists among high PIN stocks and among low PIN stocks, suggesting that PIN might proxy for an underlying factor. We create a PIN factor as the monthly return on the zero-investment portfolio above and show that it is successful in explaining returns to independent PIN-size portfolios. We also show that it is robust to inclusion of the Pástor-Stambaugh liquidity factor and the Amihud illiquidity factor. We argue that information remains an important determinant of asset returns even in the presence of these additional factors.

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