IEEE SIGNAL PROCESSING LETTERS, VOL.
27, 2020
Improved Covariance Matrix Estimation With an
Application in Portfolio Optimization
Samruddhi Deshmukh , Member, IEEE, and Amartansh Dubey , Member, IEEE
Abstract—One of the major challenges in multivariate analysis
is the estimation of population covariance matrix from the sample
covariance matrix (SCM). Most recent covariance matrix estima-
tors use either shrinkage transformations or asymptotic results
from Random Matrix Theory (RMT). Both of these techniques
try to achieve a similar goal which is to remove noisy correlations
and add structure to SCM to overcome the bias-variance trade-off.
Both methods have their respective pros and cons. In this paper,
we propose an improved estimator which exploits the advantages of
these techniques by taking optimally weighted convex combination
of covariance matrices estimated by shrinkage transformation and
a filter based on RMT. It is a generalized estimator which can
adapt to changing sampling noise conditions by performing hyper-
parameter optimization. Using data from six of the world’s biggest
stock exchanges, we show that the proposed estimator outperforms
the existing estimators in minimizing the out-of-sample risk of the
portfolio and hence predicts population statistics more precisely.
The proposed estimator can be useful in a wide range of machine
learning and signal processing applications.
Index Terms—Covariance estimator, Portfolio Optimization,
Principle Component Analysis, Random Matrix Theory.
I. INTRODUCTION
OVARIANCE matrix estimation is a crucial problem in
C multivariate statistics [1], [2] and it find applications across
many disciplines ranging from engineering [3]–[11] and physics
[12], [13] to finance [14]–[17]. It is an active area of research in
signal processing, wireless communication, machine learning
and finance [3], [16]–[23]. However, the extent of innovation
needed in estimating true correlations largely depends on the
properties of the data and trade-off between desired accuracy
and complexity. A simple estimator like SCM is useful if data
has desirable properties like multivariate normality, independent
samples, larger samples size, etc. More involved estimators
can be used for domain-specific problems when certain prior
empirical constraints are given [4]–[11].
However, in many cases, multivariate datasets do not follow
desirable properties and constraints and require more general-
ized estimators which can easily adapt to the changing patterns
and frequent outliers [24]–[27]. Financial data is particularly
challenging for traditional estimators like SCM because it does
Manuscript received April 14, 2020; accepted May 7, 2020. Date of pub-
lication May 20, 2020; date of current version June 29, 2020. The associate
editor coordinating the review of this manuscript and approving it for publica-
tion was Prof. Ya-Feng Liu. (Both authors contributed equally to this work.)
(Corresponding author: Amartansh Dubey.)
Samruddhi Deshmukh was with the Leonardo Machine Learning Division,
SAP Labs, Bangalore 560066, India. She is now with the Needl.ai, Bangalore
560066, India (e-mail: dsamruddhi21@gmail.com).
Amartansh Dubey is with the Department of Electronic and Computer En-
gineering, Hong Kong University of Science Technology, Hong Kong (e-mail:
adubey@connect.ust.hk).
Digital Object Identifier 10.1109/LSP.2020.2996060
1070-9908 © 2020 IEEE. Personal use is permitted, but republication/redistribution requires IEEE permission.
See https://www.ieee.org/publications/rights/index.html for more information.
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985
not follow desirable properties like multivariate normality and
stationarity. This has been well established by the fact that
the Nobel Prize winning minimum risk portfolio theory by
Markowitz [14] could not be effectively used in practical cases
for almost 50 years because it relies on the accurate estima-
tion of the covariance matrix [15], [17], [28]. His theory is
also referred to as the Modern Portfolio Theory (MPT) as
it radically changed the investment perspectives after the 1950s.
The key idea is to minimize the risk by avoiding investment in
highly correlated stocks (a diversified portfolio). The traditional
estimators like SCM have proved to be highly ineffective due to
the heavy-tailed nature of stock market data and availability of
limited samples [17], [28].
The amount of sampling noise present in SCM depends on
certain properties of the data. To understand this, let M be
the number of features (can be stocks in a market), N be the
number of samples (daily returns of each stock). The data matrix
can be represented as X ∈ RM ×N . After removing mean, the
SCM (ΣSCM ∈ RM ×M ) is defined as ΣSCM = XX T /N . The
following factors decide the extent of deviation of SCM from
the population covariance matrix (Σpop ):
1) Dimensionality constant (c = M/N ): SCM is an asymp-
totically unbiased estimator, i.e. ΣSCM → Σpop as N →
∞ and c = M/N ∈ (0, 1). Furthermore, the estimation
error (Σpop − ΣSCM ) is low if c → 0, i.e. N >> M
and high if c → 1. Usually, c is not close to 0 in financial
data (like stock market data) since M is comparable to N
[17]. Hence, due to the limited samples per feature, SCM
can give highly noisy correlations (high sampling noise).
2) Normality Assumption: SCM is a maximum likelihood
estimate of Σpop derived under the assumption of mul-
tivariate normality. But the distribution of stock returns is
mostly non-Gaussian and is best modeled by heavy-tailed
distributions [29]. This increases the estimation error.
3) Independence across samples: Another crucial assump-
tion made while deriving the maximum likelihood esti-
mator of Σpop is that the samples across each feature are
independent and identically distributed (i.i.d.). This is not
true for stock data as it can have temporal correlations.
4) Bias-Variance tradeoff (structure in covariance matrix):
Deviation from the aforementioned assumptions might
increase the sampling noise and cause over-fitting result-
ing in a highly non-structured SCM. This results in poor
estimates for out-of-sample correlation coefficients.
Hence, the scarcity of samples, deviation from multivariate
normality, deviation from i.i.d nature and lack of structure, all
make SCM a terrible estimator for many practical applications,
particularly for portfolio optimization [16]–[18].
986
In this paper, we propose an improved covariance matrix
estimator by taking optimally weighted convex combination of
covariance matrices estimated by shrinkage transformation and
a RMT based filter. This estimator when applied to the data
of major stock markets, outperformed the existing estimators
in minimizing the portfolio’s out-of-sample risk (test error).
A lower risk implies a better estimation of true correlations
among the stocks. Since the covariance analysis is a crucial
step in multivariate analysis, the proposed estimator can be
useful in a wide range of machine learning and signal processing
applications [3], [12], [18]–[22].
Section II provide an overview of existing methods and for-
mulates portfolio optimization problem. Section III describes
the proposed estimator followed by the empirical results in
Section IV. In all the sections upper and lower case boldfaced
letters (italic or otherwise) represent matrices and vectors re-
spectively. Italic letters represent scalars and functions.
II. SHRINKAGE TRANSFORMATIONS, RMT FRAMEWORK AND
PROBLEM FORMULATION
For an effective and concise performance analysis, we have
designed our comparative study for existing estimators which
satisfies mainly two important practical conditions. Firstly, we
have selected the existing estimators which deals with highly
unpredictable real-world financial data [17], [24]–[31], where
there are no prior constraints imposed on the behavior of either
the data or model. In other words, for this study, we have not con-
sidered several other domain-specific estimators which utilize
prior empirical constraints like restricted condition numbers or
follow specific structures in the simulated environment [4]–[11].
Secondly, we have selected those existing estimators which are
shown to be effective with the real-world data [24]–[31] and
not with the specific domain-driven simulated results [5]–[11].
However, the future work for this study can also incorporate
cross-domain comparisons. We have chosen the minimum risk
portfolio problem for comparative study because the complex
and fast-changing properties of the market data provide extreme
conditions to test the robustness of a covariance estimator. The
real-world data-driven problems like portfolio optimization have
motivated the researchers to develop better estimators to handle
financial data and these are mainly of two types: shrinkage
estimators [26]–[28] and RMT based estimators [24], [25], [30].
A comprehensive review of these estimators can be found in [17],
[31].
A. Shrinkage Transformations
Shrinkage estimators solve the overfitting problem by impos-
ing structure on SCM. The covariance values in SCM that are
extremely large due to sampling noise (and outliers) tend to
contain a lot of positive error and need to be pulled downwards.
Similarly, extremely small covariance values need to be pulled
upwards. It is done by shrinking SCM towards a highly struc-
tured matrix called a shrinkage target. The convex combination
of SCM (ΣSCM ) with a shrinkage target (F ) gives the shrinkage
estimator in (1), where, ρ is the shrinkage intensity. Its value
depends on the properties of the data.
Σshrink = ρF + (1 − ρ)ΣSCM , 0 ≤ ρ ≤ 1
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IEEE SIGNAL PROCESSING LETTERS, VOL. 27, 2020
Over the last two decades, researchers have proposed various
shrinkage estimators [26]–[28], [32]. Haff [32] was first to pro-
pose using an identity matrix as the shrinkage target. Ledoit and
Wolf [28] proposed a shrinkage target based on the Sharpe Index
model. Another famous paper by Ledoit and Wolf [27] proposed
a shrinkage target that has sample variances as the diagonal
elements and the average value of all sample covariances as the
off-diagonal elements. Hence, it is called as “Sample Variance
and Mean Covariance target”. Previous studies [17], [27] as
well as our analysis in Section IV shows that this estimator is
the best among all linear shrinkage estimators. Hence, we have
combined it in our framework in Section III. However, a major
drawback of shrinkage estimators is that they impose a uniform
structure on all covariance values and choice of a shrinkage
target is highly sensitive towards properties like non-normality
and skewness.
B. Random Matrix Theory Approach
Unlike Shrinkage estimators which uniformly add bias to
SCM, the RMT based methods exploit the asymptotic properties
of matrices in the eigen-space and add selective bias to the
unstructured SCM. Also, they do not rely on assumptions like
multivariate normality. One such technique is cleaning noisy
eigenvalues of SCM using Marchenko-Pastur (MP) law [24],
[25], [31]. MP law provides lower and upper bounds on eigen-
values such that all eigenvalues inside the bounds are associated
with sampling noise. MP law is stated as follows: Let X ∈
RM ×N be a matrix such that entries xi,j = [X]i,j are jointly
i.i.d. real random variables with zero mean and finite variance
(σ 2 < ∞) (other strict results needs the first four moments to
be finite). Let λˆ1 , λˆ2 , ...λˆM be the sample eigenvalues of SCM
(ΣSCM = XX T /N ). Since the entries of the original matrix
X are random, these sets of eigenvalues can also be viewed as
random variables. Now consider a probability measure GM (x)
on these sample eigenvalues (λˆi ) in the semi-infinite Borel set as
a count function (analogous to cumulative distribution) as shown
in (2). The derivative of (2) gives sample eigenvalue probability
density in (3).
1 ˆ
GM (x) = {λi ≤ x} (2)
M
1 
M
ΣSCM
gM = δ(x − λˆi ) (3)
M i=1
This density converges to the Marchenko-Pastur (MP) distribu-
ΣSCM
tion gM → g M P (x) as the dimensions of matrix X become
asymptotically large (M, N → ∞ and c = M/N ∈ (0, 1)). The
convergence is better if c is close to 0. The Marchenko-Pastur
distribution (g M P (x)) is given as:

(x − λ− )(λ+ − x)
g MP
(x) =
2 π c σ2 x (4)
2
 2 2
 2
λ− = σ (1 − (c)) , λ+ = σ (1 + (c))
The eigenvalues lying inside MP law bounds [λ− , λ+ ] represent
sampling noise among originally uncorrelated features and can
be replaced with a constant while keeping eigenvalues outside
these bounds intact. The eigenvectors of SCM can be scaled
(1) with these new eigenvalues to obtain cleaner covariance matrix
DESHMUKH AND DUBEY: IMPROVED COVARIANCE MATRIX ESTIMATION
(ΣM P ). This technique is called Eigenvalue Clipping [17] and
unlike shrinkage techniques, it selectively adds bias to noisy
correlations. Another recent development in RMT to clean SCM
is that of Rotationally Invariant Estimator [31]. However, this
method does not give a significant improvement over Eigenvalue
Clipping for small datasets [17] (also shown in Section IV) and
requires heavier numerical computations.
There are some disadvantages of RMT based methods. For
example, Eigenvalue Clipping completely overlooks the fact
that extreme eigenvalues lying outside the MP law bounds can be
overestimated and can increase the sampling noise [17]. Further-
more, these results are derived under asymptotic assumptions
which can be misleading when the available sample size is small.
The RMT based methods also require finite variance and i.i.d.
nature in data which might not be true for heavy-tailed financial
data having high temporal correlations. Thus, both shrinkage
and RMT techniques have their pros and cons depending on the
properties of the data.
C. Formulation of Portfolio Optimization Problem
The conventional problem of finding the minimum risk port-
folio is a convex problem with linear constraints [14]. We have
included an additional return constraint for our study because
even a risk-averse investor would expect a minimal positive
return. This gives the following problem formulation:
minimize var(pT X) ( ≈ | pT (ΣSCM ) p |2 )
p
subject to 1T p = 1, p  0, g T p ≥ rdaily
M ×N
where, X ∈ R is the stock return matrix for M stocks, each
with N number of daily returns. The portfolio vector p ∈ RM ×1
is the optimization variable and ‘var’ represents variance. The
vector g ∈ RM ×1 represent the predicted daily returns of M
stocks and it can be estimated using recurrent neural networks
[34] or simply by dividing the available data into training and
test sets. The threshold rdaily is the minimum daily expected
return. The objective function var(pT X) can be approximated
as |pT ΣSCM p|2 . The first constraint in (5) implies that the sum
of all portfolio weights should be one. The second constraint
forces the portfolio weights to be positive, since we are not
considering a short-selling scenario [28]. The third constraint
specifies the minimum expected return. The problem in (5) tries
to find a vector p in M dimensional feature space on which the
projection of data is minimum while satisfying the constraints.
Therefore, estimation of covariance matrix is the key step for
solving (5).
III. PROPOSED ESTIMATOR
In this section, we propose an improved covariance estimator
which exploits the advantages of both shrinkage and Eigenvalue
Clipping approaches by taking an optimally weighted convex
combination of the high variance ΣSCM , a highly structured
shrinkage target F and a matrix obtained by applying Eigenvalue
Clipping (ΣM P ). The formulation of the proposed estimator
(represented as Σ∗ ) is shown in (6).
Σ∗ = α F + β ΣM P + γ ΣSCM
where α + β + γ = 1 and α, β, γ ≥ 0
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987
Here, the shrinkage target F is the Sample Variance and Mean
Covariance target (explained in Section II-A). The optimization
problem for finding optimal weights is given as:
minimize |Σpop − Σ∗ |F
α,β,γ
subject to Σ∗ = α F + β ΣM P + γ ΣSCM
α + β + γ = 1, α, β, γ ≥ 0 (7)
Where, | · |F is Frobenius norm. The problem with three
variables (α, β, γ) in (7) can be simplified to (8) with two
variables (θ, φ).
minimize |Σpop − Σ∗ |F
θ,φ
subject to Σ∗ = [θF + (1 − θ)ΣM P ]φ + (1 − φ)ΣSCM
0 ≤ θ ≤ 1, 0 ≤ φ ≤ 1 (8)
Similarly, proposed estimator in (6) can be rewritten as (9). The
effective weights of F , ΣM P and ΣSCM are now θφ, (1 − θ)φ,
and (1 − φ) respectively.
Σ∗ = θφ F + (1 − θ)φ ΣM P + (1 − φ) ΣSCM (9)
In practical cases, Σpop is not known and hence for a given
values of (θ, φ), we cannot decide how close is Σ∗ to Σpop .
Hence, problem in (8) cannot be solved directly. However, we
know that the Markowitz theory (MPT) optimally minimizes the
risk associated with a portfolio if a given estimator accurately
(5) predicts the population correlations (Σ∗ → Σpop ) [17], [24]–
[27]. Therefore, to find optimal values of (θ, φ) which solves
(8), we rewrite MPT problem in (5) as (10) and solve it multiple
times iterating over the values of both θ and φ from 0 to 1 with
sufficiently high resolution until we get minimum value of the
objective function in (10).
minimize | pT Σ∗ (θ, φ) p |2
p
subject to 1T p = 1, p  0, g T p ≥ rdaily (10)
Solving (10) for fixed values of (θ, φ) requires eigen-
decomposition of symmetric positive semi-definite matrix which
has worst case complexity of O(M 3 ) [35]. Furthermore, the
number of times problem in (10) needs to be solved depends
on the choice of increment step used to iterate values of both
θ, φ from 0 to 1. Hence, (θ, φ) are the hyper-parameters in (10)
which needs to be searched on a 2-D dimensional grid. It is
important to note that in portfolio optimization problems, the
computational complexity is not exclusively discussed because
of the limited sized datasets involved [16]–[18], [30]. In fact, ac-
curacy becomes more important than computational complexity
when using limited sized datasets. Therefore, this paper focuses
on accuracy rather than computational cost. However, several
faster methods for decomposition of covariance matrices can be
explored as part of future work [35]–[38]. Similarly, for high
dimensional applications, the grid search for hyperparameters
can be accelerated using various methods in field of fast hyper-
parameter tuning [39]–[41].
This estimator is simple but very effective in removing the
(6) shortcomings of shrinkage estimators and Eigenvalue Clipping
filter. We know that shrinkage transformation adds bias to all
988
TABLE I
ANNUALIZED OUT-OF-SAMPLE RISK FOR MINIMUM VARIANCE PORTFOLIO (WITH CONSTRAINT OF ACHIEVING ATLEAST 10% RETURN) FOR NSE, NIKKEI, S&P
AND BSE DATASETS USING DIFFERENT ESTIMATORS (IN TERMS OF % STANDARD DEVIATION)
TABLE II
RESULTS FOR NASDAQ AND NYSE DATASETS
sample covariance values uniformly. On the other hand, Eigen-
value Clipping selectively removes and replaces noisy eigenval-
ues inside MP law bounds but ignores the noise in extreme eigen-
values. This means, Eigenvalue Clipping is efficiently removing
the noisy correlations between the features which are originally
uncorrelated. But it is ineffective in removing the noisy correla-
tions between the features which are originally highly correlated.
Whereas, shrinkage estimator is opposite in its ability. So when
we take the weighted convex combination of both shrinkage
and Eigenvalue Clipping estimators, we not only remove noisy
eigenvalues inside the MP law bounds, but also shrink extreme
eigenvalues lying outside the bounds. Hence, noisy correlations
among both correlated and uncorrelated features can now be
handled. Furthermore, this provides a generalized estimator that
can adapt to different datasets by changing the values of θ and φ.
IV. DATA AND EMPIRICAL RESULTS
We have compared following five estimators with our pro-
posed estimator (Σ∗ ): 1) Identity Matrix (ΣIdentity ) proposed
by [32]. It assumes that there is no correlation among stocks; 2)
Shrinkage Estimator (ΣShrinkage ) proposed in [27]. It is shown
to be most efficient linear shrinkage estimator [17], [27]; 3) Sam-
ple Covariance Matrix (ΣSCM ); 4) Eigenvalue Clipping based
estimator (ΣM P ); 5) Rotational Invariant Estimator (ΣRIE )
recently proposed by Bun et al. [24], [31].
For comparing these estimators, we consider stocks from six
major stock exchanges: NSE, NIKKEI, BSE, S&P, NASDAQ
and NYSE. We solved the problem formulated in (10) for each
dataset to minimize the investment risk while satisfying the
minimum 10% return constraint. We have selected 100 most
liquid stocks from each of the exchanges, with 750 days (Jan,
2014 to Jan, 2016, around 2 years) of daily returns data for each
stock. We also avoided selecting stocks which are common in
multiple American exchanges. The daily returns for the first 200
days are used to train the initial minimum risk portfolio using
six estimators shown in Tables I and II. Hence the size of the
data matrix is 100 × 200, i.e., dimensionality constant c = 0.5.
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IEEE SIGNAL PROCESSING LETTERS, VOL. 27, 2020
We then shift this 200 days training window forward and update
the portfolio at frequencies of 30, 60 and 90 days and record the
variance of the daily returns in each case. We have used only 200
days of daily returns for training because in finance, using recent
data is preferable to capture the effects of the recent trends.
The comparisons shown in Tables I and II is based on the
variance (volatility) of daily returns associated with portfolios
obtained by various estimators. The volatility is calculated for
the test data (out-of-sample risk). This variance is converted
to percentage√ standard deviation and annualized by multiply-
ing it with 365. The results are shown for portfolio update
frequencies of 30, 60 and 90 days. It can be seen that the
proposed estimator gives the lowest out-of-sample risk for all
six datasets and for all the update frequencies. A decrease in
volatility even at the first decimal place is considered as fairly
significant in the field of portfolio optimization [17], [27], [28].
Based on this benchmark, the margin of improvement given
by proposed estimator is significant in all the datasets except
for 30 days update frequency in NASDAQ. In most cases, the
identity matrix (ΣIdentity ) is the worst estimator (except for
BSE) which is expected as it assumes zero correlations among
stocks. SCM is the second-worst. Also, the proposed estimator
gives good results even when the update frequency is low, i.e. 90
days. This shows that the proposed estimator predicts the future
correlations more precisely.
V. CONCLUSION AND FUTURE WORK
In this paper, we proposed an improved covariance matrix
estimator which exploits the advantages of both shrinkage and
RMT based estimator. It first uses MP law to clip noisy eigenval-
ues lying inside the MP law bounds, thus adding selective bias,
and then uses shrinkage techniques to shrink extreme covariance
values, thus reducing error in them. Hence, noisy correlations
among both correlated and uncorrelated features can now be
handled. Also, this provides a generalized estimator that can
adapt to different datasets by tuning its parameter using training
data.
We used data from six of the world’s largest stock exchanges
and showed that our proposed estimator outperforms all existing
estimators in minimizing the out-of-sample risk of the portfolio.
This implies that it efficiently predicts the true correlations
among stocks and by extension, among any set of multivariate
features. Hence it can also be useful in other fields dealing with
the covariance matrices including machine learning and signal
processing. The performance and computational efficiency for
large dimensional problems can be investigated as part of future
work.
DESHMUKH AND DUBEY: IMPROVED COVARIANCE MATRIX ESTIMATION
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