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Don't try to time end of bull market — do this instead

The bears haven't exactly gotten their way. Even with global economic forecasts ratcheted down, the S&P 500 moving sideways and an earnings outlook that isn't great, stocks have proved resilient.

Calling the end of a bull market is tricky, and this one has already outlasted many other previous stock runs.

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Raymond Boyd | Getty Images

But if you're convinced stocks are going to plod along at best — with every short rally followed by a volatile pullback — or think stocks are still due for a correction, you don't need to exit the market entirely. The bearishly inclined have more options than ever to suit their degree of pessimism.

A recent S&P Capital IQ report suggests proceeding with caution. "There are very few times that a bull market has lasted this long," said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ. "There's not a lot of history."

The traditional approach to taking risking off the table and holding bonds is not very attractive in the current rate environment.

Rosenbluth said he can understand why some investors prefer to ease off their exposure to stocks, and after years of underperforming, some exchange-traded funds (ETFs) with a bearish slant are finally doing okay.

The basics

The first thing investors need to do is take their risk temperature before stepping into bearish ETFs. There are three categories the bearish ETFs fall into:

1. The most pessimistic take short positions in a select group of what they consider to be the poorest-quality stocks, likely to falter in bear markets. Or there are ETFs that generate the inverse (or opposite) performance of a broad stock market index and often use leverage (e.g. 2x or 3x bear market ETF).

2. What you might call "semi-pessimistic" ETFs take long positions on their favorite, typically more conservative stocks, while shorting a broad stock index.

3. The more bullish of these bearish ETFs are low-volatility stock ETFs, targeting stocks with the cash streams and dividend yields designed to ride out rocky times.

For long-term investors who want to stay in the market but reduce risk, the low-volatility/minimum-volatility ETFs make sense.

The iShares MSCI USA Minimum Volatility is a good option, said Ben Johnson, Morningstar's global director of ETF research. This ETF tracks a low-volatility index, and the holdings include big, dividend-paying blue-chip stocks such as AT&T, Verizon and McDonald's.

Johnson said even if it's the recent volatility that has investors on edge, they should not think of these ETFs as short-term trading vehicles. "Investors are served by long-term solutions like these ETFs," Johnson said. "They're for all seasons and will take the sting out of market volatility."

PowerShares S&P 500 Low Volatility ETF is in the same category. The ETF buys the 100 stocks in the S&P 500 with the lowest volatility over a 12-month time span. Current holdings include Coca- Cola and PepsiCo.

"This ETF gives you equity exposure and will suffer less when the market turns south," Johnson said.

A third option is the SPDR MSCI USA Quality Mix ETF, which also tracks an index designed to identify quality-value stocks with low volatility.

All three have done well in the past one-year period when compared to the S&P 500 return:

  • iShares MSCI USA Minimum Volatility:8 percent
  • PowerShares S&P 500 Low Volatility ETF: 8 percent
  • SPDR MSCI USA Quality Mix ETF: 3 percent (since inception on April 15, 2015)
  • S&P 500: -3 percent
    (Source: XTF.com)

Ben Doty, a senior investment director at Koss Olinger Financial Group, said these ETFs can help investors to minimize stock declines. He said low-risk, low-volatility stocks have historically outperformed higher-risk stocks over time. "That's a compelling case for low-risk stocks," Doty said. But he cautioned that these are stock funds and still too volatile to ever be confused for a bond replacement. When the stock market is down, these ETFs will provide investors with a "smaller hole to climb out of," he said.

Minimum-volatility ETFs do deserve to be considered long-term holdings, said Neena Mishra, director of ETF research at Zacks Investment Research. "They are also usually big, highly liquid, pay good yields and have low expenses," she said.

The low-volatility ETFs do all have reasonably low expense ratios:

  • iShares MSCI USA Minimum Volatility: 0.15 percent
  • PowerShares S&P 500 Low Volatility ETF: 0.25 percent
  • SPDR MSCI USA Quality Mix ETF: 0.15 percent

The short game

Some ETFs have the option of moving between long and short positions in stock indexes, using dynamic hedging.

The recently launched Wisdom Tree Dynamic Bearish U.S. Equity ETF is an example. It is made up of three components: an index of 100 mid- and large-cap stocks that screen highly on fundamental growth and value metrics, an index of the 500 largest U.S. stocks that is being shorted and a long position in Treasuries. The "dynamic" model means the ETF can change its exposure to the long and short indexes based on the manager's overall view of the market. It can be, at maximum, 25 percent exposed to equities and is, at minimum, always 75 percent hedged.

"This ETF makes sense when you're worried about the direction of the market," Mishra said.

The ETF is new, having launched Dec. 23, 2015. Since inception, DYB is up 6 percent versus a flat S&P 500. It has an expense ratio of 0.48 percent.

Another recent WisdomTree ETF that uses the same long and short indexes is the WisdomTree Dynamic Long/Short U.S. Equity Index. It can maintain 100 percent exposure to the long index, while moving exposure to the short index anywhere from zero to 100 percent. Since inception, also Dec. 23, 2015, this ETF is up 2 percent. It also has an expense ratio of 0.48 percent.

Keeping the shorts on a short leash

A similar niche has been carved out by the Pacer ETFs, which offers three ETFs that can "toggle" between exposure to large-, mid- and small-cap stocks and Treasury bonds.

One issue with these ETFs is that, unlike the low-volatility funds that are inherently bullish with a more moderate risk profile, these ETFs don't just have a long position — they are relying on a manager to correctly time the market. Dynamic hedging ETFs with a longer history have whipsawed in the past, and performance suffered. As the old investor saying goes, When you try to time the market, you need to be right twice: on the way out and on the way back in.

"It does come down to timing," said Paul Britt, senior ETF analyst at FactSet Research Systems.

But Britt said these ETFs make some sense for do-it-yourself investors who might be inclined to pursue a market-timing strategy on their own. These ETFs use a set of rules to determine when to keep the risk on and when to take it off.

"If you are the kind of person who wants something that is smart enough to get out when things are really bad and you don't trust yourself to execute, too wrapped up in the moment," these ETFs are a viable option, Britt said.

Other ETFs go further — maybe too far, critics say — using riskier strategies to focus exclusively on shorting individual stocks.

Take the AdvisorShares Ranger Equity Bear ETF. It typically shorts U.S. mid-cap growth companies with poor earnings quality and that use aggressive accounting. They're more apt to miss future earnings expectations, said John Del Vecchio, Ranger Equity Bear's co-portfolio manager. "We read SEC filings that no one else reads," he said. "We look for dogs."

Del Vecchio said shorting the entire market is a terrible strategy compared to identifying overvalued stocks.

Other experts agree but would not necessarily exclude the Ranger Bear Equity ETF from the skepticism.

Year-to-date, HDGE is up 1.5 percent. But this ETF has trailed the S&P 500 in the past three-year period and the since-inception (2011) period.

"Traditional diversification is not that attractive right now." -Paul Britt, senior ETF analyst at FactSet Research Systems

Of the two portfolio managers listed for the Ranger Bear Equity ETF in its Statement of Additional Information, only Del Vecchio has made a personal investment in the fund, and only at the level of $1,000 to $10,000, not a significant vote of confidence in the fund, according to mutual fund analysts who track managers' personal investments in the portfolios they run.

"No one who is bearish should invest in a shorting ETF," said Doty at Koss Olinger Financial Group. "Your losses can be theoretically infinite, because the market moves quickly and undermines returns.

"So the potential for being wrong is very dramatic," he added.

This applies more brutally to leveraged and inverse ETFs that seek 2x or 3x exposure to a long or short index, where losses can compound in a hurry due to the use of derivatives and short positions.

The managers of these riskier ETFs use a variety of strategies, including derivatives and shorting stocks, to meet their objectives. If underlying stocks or indexes go up, inverse ETFs will have to reduce their short exposure by maybe buying stocks at higher prices, which would lead to underperformance.

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An ETF like Ranger Bear, shorting stocks, doesn't face that issue, but shorting stocks is expensive and results in a high expense ratio. It's also very risky and can result in big losses. "I never recommend ETFs that have such high expense ratios, since they will have to really outperform the market so as to justify these kind of fees," said Mishra at Zacks Investment Research.

Shorting ETFs may appeal to traders and investors looking for a short-term opportunity but should never be used as long-term investments, according to Mishra. And any fund with leveraged or inverse exposure to the market is intended for a single-day trade only.

"We haven't done well during the market rebound," said Ranger Equity Bear's Dell Vecchio. "But we provide insurance for portfolios. There's a butt-kicking coming. It will hurt a lot of people. But we don't know if it's this year."

"I can't find a single reason to give this ETF anything resembling an endorsement," Johnson said. He pointed to a simpler, traditional investment option for investors pessimistic about the stock market that should not be neglected: "There are far better ways to hedge against volatility, such as low-cost diversified bond ETFs," he said.

Britt said the bond argument is always a valid one, but with yields so low right now, there is an opportunity cost to sitting in Treasuries all the time. That's one reason why all of these other risk modifications strategies are trending. "Traditional diversification is not that attractive right now," said Britt at FactSet Research Systems.

By Constance Gustke, special to CNBC.com