Portfolio diversification amid economic uncertainty in Pakistan: empirical evidence from the quantile-on-quantile approach

• Our work applies a quantile-on-quantile framework to study the quantile-specific impact of EPU on sectoral returns in Pakistan. • Banking and insurance sectors are highly sensitive to EPU in extreme market conditions. • Automobile & Assembler, Oil and Gas, and Refinery sectors respond negatively to EPU at higher quantiles. • Cement, Technology & Communication sectors respond positively across higher and negatively across lower quantiles to EPU. • Our findings can facilitate investors and portfolio managers in risk management and provide better diversification. Over the past few decades, Economic Policy Uncertainty (EPU) has become a key driver of financial market dynamics, which influences investment decisions, risk perceptions, and overall economic stability. Therefore, our objective is to examine the impact of EPU on sectoral stocks in Pakistan. For the empirical analysis, we take monthly data from August 2010 to December 2023, and employ quantile-on-quantile regression approach (QQR) for the empirical analysis. This approach captures nonlinear and asymmetric relationships across different market conditions, thus making it ideal to analyze sectoral heterogeneity in response to changes in EPU. Our results highlight the negative effect of EPU on the returns in the Automobile & Assembler, Oil and Gas, and Refinery sectors at higher quantiles, whereas Banking and Power & Distribution sectors across all quantiles. However, in the Cement, Insurance, and Technology & Communication sectors, EPU positively affects returns at lower quantiles, whereas it negatively affects returns across higher quantiles. Policymakers should prioritize enhancing transparency and maintaining consistency in economic policies to minimize market disruptions caused by uncertainty. For portfolio managers, understanding the asymmetric impact of EPU can facilitate more effective risk management and asset allocation strategies, thus providing better diversification and hedging opportunities against uncertainty.