Since late July global financial markets have experienced the most extreme volatility since 2010, putting to the test many of the risk protections that were put in place following the financial crisis of three years ago.

A flight to safety, sparked by slowing global growth, the loss of the U.S.’s triple-A credit rating and the escalating debt crisis in Europe, has wiped out $7.9 trillion in global equity value since July 26; the Standard & Poor’s 500 index fell 17.6 percent between July 22 and August 10. The week saw sharp swings both up and down. The S&P lost 6.66 percent on Monday, August 8, the first trading session after the downgrade. It gained 4 percent on Tuesday after the Federal Reserve announced it would hold rates steady until mid-2013. Equity markets lost ground on Wednesday amid fears over Europe. On Thursday the S&P rose 4 percent as investors looked for value and questioned whether stocks were oversold. On Friday the S&P rose more than 1 percent in midafternoon trading.

In short, it was just the sort of week that a new generation of risk management tools were designed to handle. Were they up to the task? Institutional Investor spoke with several chief investment officers about how their risk analytics fared and how they are currently positioned.

Strategist: Daniel Loewy, co–chief investment officer and head of research for dynamic asset allocation at Alliance­Bernstein, which has $456 billion in assets under management.

Approach to risk management: AllianceBernstein has developed a tool called Dynamic Asset Allocation that analyzes dozens of metrics, such as volatility, to constantly adjust the allocation of assets in a portfolio. It doesn’t try to forecast specific crises in the market but monitors the markets for warning signs that risk is rising. Teams of analysts assess whether investors are properly compensated for those risks and adjust asset allocation accordingly.

How it performed: Loewy became concerned about rising levels of risk in July. The biggest worry: widening spreads between German debt and the debt of Italy and Spain. As those spreads surpassed 200 basis points — the level that indicated trouble the year before in Greece – an alarm went off. Greece accounts for just 5 percent of euro zone debt, but Italy is the third-largest debtor nation in the world, after the U.S. and Japan, and its economy is much larger than Greece’s. Sustained periods of very high funding costs for Spain or Italy would be a disaster for those countries’ banks and economies. “We were also concerned about rising commodity prices, a likely headwind to growth, and a little concerned about tightening in emerging markets,” Loewy says.

So beginning in July at AllianceBernstein the Dynamic Asset Allocation strategies and accounts began cutting back on risk. In one insurance fund equity exposure was reduced from 60 percent to 47 percent. “We were able to make the shift before the dislocations of the last couple of days, and as a result, our products have been more protected,” Loewy says.

Funds and accounts that use dynamic asset allocation experienced smaller losses than comparable static allocation strategies. For example, an Alliance­Bernstein fund for smaller insurance companies lost 4.2 percent between July 31 and August 8. Its benchmark — an index allocated 60 percent to the MSCI world equity index and 40 percent to Treasuries — fell 5.5 percent.

Outlook: “U.S. volatility is high and is likely to remain high for an extended period,” says Loewy. “We have weak growth, political gridlock and, in effect, currency wars going on here. But that being said, valuations are coming in and yields are falling, so investors are getting paid a bit more to take on that risk.”

Strategist: John (Launny) Steffens, founder of New York-based Spring Mountain Capital, which has $1.58 billion in assets under management. Steffens launched SMC in 2001, after a 38-year career at Merrill Lynch & Co., where he had risen to vice chairman. SMC invests in alternative funds managed by third parties such as hedge fund and private equity firms.

Approach to risk management: Tactical asset allocation. Steffens says tactical asset allocation is different from portfolio diversification because it overweights assets that are expected to outperform the market and “actively assesses whether or not it’s prudent to take risk, and if it is, what type of risk is appropriate.”

How it performed: SMC's Reserve Fund II, a hedge fund of funds, was up 2 percent for the year to date, compared with 9.96 percent for all of 2010, according to an investor letter, which was obtained by Institutional Investor.  SMC's Reserve Fund II Offshore was up 2.9 percent for the year to date, compared with 11.79 percent for all of 2010, according to the letter.

Outlook: “I would be on the quite conservative side of portfolio management today,” Steffens says. He is worried about the European debt crisis, U.S. economic growth, and U.S. fiscal outlook. “It really wasn’t that hard to figure out that the euro zone needed a solution to its structural problems and that the solution wouldn’t be possible,” he says. A breakup of the euro zone or a tighter fiscal union is advisable, but unlikely to happen. So he cut back on exposure to equities. “Two weeks ago I gave a speech and suggested an allocation of 25 percent in cash, 10 percent in gold, 30 percent in high-quality equities and 35 percent in fixed-income investments such as high-quality corporates or municipals,” Steffens says. Today he would make a similar recommendation but take some high-quality bonds off the table and put the money into high-dividend-paying stocks such as Microsoft Corp., Merck & Co, Johnson & Johnson and “maybe AT&T.” For some clients, he might suggest out-of-the-money options to provide some downside protection.

Strategist: Stephen Johnson, U.S. chief investment officer for DB Advisors, Deutsche Bank’s institutional asset management business. Total assets under management: about $238 billion.

Approach to risk management: Johnson works with DB Advisors analysts, asking them to assess how the markets they cover would react to various scenarios. After S&P issued its first warning that it might downgrade U.S. sovereign debt, Johnson asked analysts to study how their markets would be affected. Then he shared that information with portfolio managers. “It wasn’t entirely an exact science, but it got our teams thinking about how we may need to modify portfolios,” he explains.

How it performed: “Our positions were pretty benign, relative to normal levels of risk, before the volatility of the last few days, and I think they were good positions,” Johnson says. “We had a very minor overweight in a number of spread sectors. Right now our biggest overweight is in corporates. We are underweight in mortgages.”

Outlook: “We are still neutral in most structured finance, although we have a minor overweight in CMBS [commercial-mortgage-backed securities]. Once we see the economy stabilize and liquidity return to where it needs to be, we would expect to invest in more credit of financial institutions. But before then we need to see a better growth picture domestically.”