Limits-to-Arbitrage in US Penny Stocks: An Overlooked Segment of US Equity Markets

Abstract

This paper investigates a largely overlooked segment of U.S. equity markets, listed penny stocks. We find that: (i) the average percentage of short interest ratio of listed penny stocks is 14% which is not significantly different from that of NYSE- and NASDAQ-listed stocks ranging from 10% to 20%; and (ii) 29% of the listed pennies are held by institutional investors on average, contradicting the general perception that institutional investors avoid listed penny stocks. These two surprising facts combined with observed extreme illiquidity and high idiosyncratic volatility, all significantly affect abnormal returns from investment in listed penny stocks. We focus on these four factors as an indication of limits-to-arbitrage in explaining unusual valuation of listed penny stocks.