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End-to-End Neural Shrinkage of Indefinite Pairwise Correlation Matrices for Small-Cap-Inclusive Portfolios

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  • Christian Bongiorno
  • Lorenzo Villassero

Abstract

Small-cap-inclusive equity universes contain recently listed and intermittently traded securities, so enforcing a common look-back discards a substantial fraction of the available information. Pairwise-complete estimation preserves the longest overlap for each asset pair, but the resulting correlation matrix can be indefinite because its entries are computed on different samples. This prevents direct use in Markowitz optimization and falls outside the assumptions of standard random-matrix shrinkage. We adapt a rotation-invariant neural covariance estimator to this setting. The model computes mask-aware marginal moments and a pairwise correlation matrix proxy, processes its signed spectrum, and uses a bidirectional gated recurrent unit conditioned on factor-aligned effective sample lengths derived from the overlap matrix and eigenvector loadings. It maps all eigenvalues, including negative ones, to a positive inverse spectrum. The reconstructed covariance is positive definite and is trained end-to-end to minimize five-day realized global-minimum-variance risk. We evaluate 26 expanding-window models from 2000 to 2025 on up to 1,500 U.S. equities in a closing-auction simulator with point-in-time selection, commissions, financing, corporate actions, and market impact. Across the 26-year out-of-sample period, the neural estimator reduces annualized five-day volatility by approximately 20\% and increases the Sharpe ratio by approximately 40\% relative to the next-best covariance estimator. These improvements are consistent across realized risk, risk-adjusted performance, and drawdown control, remain after the modeled execution frictions, and are supported by a 99.9\% Model Confidence Set that retains only the neural estimator.

Suggested Citation

  • Christian Bongiorno & Lorenzo Villassero, 2026. "End-to-End Neural Shrinkage of Indefinite Pairwise Correlation Matrices for Small-Cap-Inclusive Portfolios," Papers 2608.30446, arXiv.org.
  • Handle: RePEc:arx:papers:2608.30446
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    References listed on IDEAS

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    1. Christian Bongiorno & Efstratios Manolakis & Rosario Nunzio Mantegna, 2025. "End-to-End Large Portfolio Optimization for Variance Minimization with Neural Networks through Covariance Cleaning," Papers 2507.01918, arXiv.org, revised Apr 2026.
    2. Shihao Gu & Bryan Kelly & Dacheng Xiu, 2020. "Empirical Asset Pricing via Machine Learning," Review of Finance, European Finance Association, vol. 33(5), pages 2223-2273.
    3. Stambaugh, Robert F., 1997. "Analyzing investments whose histories differ in length," Journal of Financial Economics, Elsevier, vol. 45(3), pages 285-331, September.
    4. Cahan, Ercument & Bai, Jushan & Ng, Serena, 2023. "Factor-based imputation of missing values and covariances in panel data of large dimensions," Journal of Econometrics, Elsevier, vol. 233(1), pages 113-131.
    5. Peter R. Hansen & Asger Lunde & James M. Nason, 2011. "The Model Confidence Set," Econometrica, Econometric Society, vol. 79(2), pages 453-497, March.
    6. Shihao Gu & Bryan Kelly & Dacheng Xiu, 2020. "Empirical Asset Pricing via Machine Learning," The Review of Financial Studies, Society for Financial Studies, vol. 33(5), pages 2223-2273.
    7. Fischer, Thomas & Krauss, Christopher, 2018. "Deep learning with long short-term memory networks for financial market predictions," European Journal of Operational Research, Elsevier, vol. 270(2), pages 654-669.
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