Emerging markets have been far and away the best-performing equity asset class over the past decade. The MSCI Emerging Markets Index has posted an annualized 10.6% 10-year gain through the end of 2010, pushing it ahead of even mid-cap and small-cap domestic stocks.

Market Index

Covered Asset Class

10-Year Annualized Return Through Dec. 31, 2010

MSCI Emerging Markets Index Foreign emerging 10.6%
Russell Midcap Index Mid-cap domestic 6.7%
Russell 2000 Index Small-cap domestic 5.5%
MSCI EAFE Index Foreign developed 1.8%
S&P 500 Index Large-cap domestic 0.4%

Source: Morningstar.

There's no denying that emerging markets have been on a tear lately, but just as everyone has begun to pin their hopes on the asset class, some cracks in the surface are appearing.

Fleeing the scene
Just as we're starting to see in the bond market, it won't take much to spook investors and send them running. The political turmoil in Egypt has apparently lit a fire under some folks' feet, prompting them to yank their money out of emerging market investments entirely. According to data from EPFR, investors worldwide have pulled more than $7 billion out of emerging market funds in the week ending Feb. 2. Furthermore, emerging markets have generally turned in a negative performance so far this year, with the iShares MSCI Emerging Markets Index ETF (NYSE: EEM) down 2.3% so far this year.

There are a couple of dangers here. First, there is the possibility that the unrest in Egypt could spread throughout the Middle East, drawing more nations into political quagmire and hurting the investing outlook for this region. There is also the fear that this panicked selling could become self-reinforcing and could lead to even greater price pressures on emerging markets. Given existing concerns over rising inflation in fast-growing nations such as India and China, whose most recent inflation rates clocked in at 9.5% and 4.6%, respectively, there is a genuine concern that emerging markets could be on the cusp of overheating. China, India, Brazil, South Korea, and now Indonesia have all recently raised interest rates in an attempt to choke off inflation. Even if other developing nations aren't facing runaway inflation, India, China, and Brazil are big enough on the world stage to really take down diversified emerging market investors if they run into further inflationary troubles.

Risk on the rise
Also adding to the risks here, emerging markets attracted a record $95 billion in assets last year, no doubt thanks to the sector's stellar recent performance. I've warned several times before that investors shouldn't expect this sector to continue producing the high level of returns that it has in recent years. Given that valuations are elevated and returns have been category leaders in recent history, there is a greater chance of emerging markets taking a breather than them continuing on their current path. Of course, this isn't to say that developing markets don't have meaningful long-term growth opportunities, but near-term risks are rising.

So if emerging markets are a good long-term play but face near-term headwinds, what's a prudent investor to do? Well, the first step is to take stock of how much direct emerging markets exposure you do have. Even for the most aggressive investors, it probably shouldn't be much more than 8% to 10% of your portfolio right now. More conservative types probably don't want to go much above 3%, if they want any exposure at all. If you haven't rebalanced your portfolio in a while and cut back on some of your winners, do that soon. Now is probably not the time to leave extra money on the table in this area.

Diversifying danger
However, I don't recommend fleeing emerging markets entirely or cutting back your allocation significantly below your long-term target. While I think the sector may be due for a pullback, I don't think it makes sense to try to time the market. Rather, keep your existing allocation but put any new money to work in other areas of the market, preferably one like domestic large caps that are much more undervalued on a relative basis. That's the whole idea behind buying low and selling high -- redeploying your capital to areas of greater opportunity.

Lastly, take a look at what emerging markets investments you own. With markets as risky as they are now, you really want to make sure you are diversified across regions and countries. Here, low-cost exchange-traded funds like Vanguard Emerging Markets Stock ETF (NYSE: VWO) or Schwab Emerging Markets Equity ETF (NYSE: SCHE) are a good tool for any investor. If you prefer an actively managed emerging markets play, consider a fund like T. Rowe Price Emerging Markets Stock (PRMSX), which takes a broad-market investing approach. Manager Gonzalo Pangaro focuses on industry leaders with strong earnings potential selling at reasonable prices, such as Mexican telecom firm America Movil (NYSE: AMX) and Brazilian metals and mining company Vale (NYSE: VALE), which trade at P/Es of 17 and 13, respectively. The fund is not without volatility, but it still offers good long-term potential.

Time will tell whether the current blip in emerging markets' fortunes is temporary or the start of a more pervasive downward trend. Either way, a reasoned approach and long-term focus will be keys to capitalizing on the next phase in the market cycle for this increasingly important segment of the global market.

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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. America Movil is a Motley Fool Global Gains recommendation.The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days.

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