* Euro zone threat sees markets tumble
* Volatility rises as investors await policy steps
* Value draws in some betting euro zone avoids break-up
* Funds up exposure but still underweight regional stocks
By David Brett
LONDON, May 25 (Reuters) - Glass half-full investors who are able to stomach short-term volatility are being lured into European equities by cheap valuations, anticipating rewards if policymakers can ultimately contain the euro zone crisis.
With Greece's potential exit from the 17-country currency bloc no longer taboo since voters hammered parties supporting the country's international bailout in a May 6 election, shares have tumbled. [I D :nL5E8GM3L0]
European equities have fallen 13 percent over the past two months and the scale of daily market swings has nearly doubled - with indexes in the weaker countries on the euro zone periphery even worse hit.
Spain's IBEX, heavily weighted towards financials, is at lowest in nine years as the country battles to reform its banking system and meet austerity targets, while the Athens benchmark index is at all-time lows.
While many strategists predict further falls in the short term, particularly in the run-up to a second Greek election on June 17, the steep sell-off has left stocks looking attractive on many valuation measures and opened up opportunities for some buy and hold investors with a longer-term time horizon.
"We are seeing a drag on equity markets and we have the view that there are certain levels which for a long term investors are an opportunity to buy," said Oliver Wallin, investment director at Octopus Investments, which has some 2.5 billion pounds ($3.92 billion) under management.
"For us it's more of a risk-back-on trade. We are buying into the UK equity market, a little bit of European equity market through ETFs [Exchange-Traded Funds], buying in at the sidelines into highly liquid instruments that we can unwind if things take a turn for the worse," he said.
In the first week of May, asset allocators increased their weightings in euro zone and UK equities, bucking a longer-term downward trend, although they remained 'underweight' overall, a survey of fund managers by Bank of America Merrill Lynch showed.
Despite record low yields, the survey showed asset managers raised their exposure to government bonds and cash, the latter to abnormally high levels, leaving plenty of room for more exposure to equities once the euro zone crisis is resolved.
Many of those taking the plunge and buying in spite of the euro zone debt jitters are betting policymakers will take decisive steps to prevent contagion even if Greece does leave.
"Governments will hold peripheral economies' feet to the fire but will eventually come in with a policy response ... because the consequences (of inaction) are that things will unravel fairly quickly," David Leduc, chief investment officer at Standish Asset Management, said.
If that does not happen and the euro zone disintegrates, analysts say current valuation measures may be of little use as equity markets collapse.
According to Credit Suisse research only 12 percent of investors expect a full-fledged euro area break up by the end of the year, and nearly a third reckon that European assets provide the best risk/return trade-off.
Hector Kilpatrick, chief investment officer at Cornelian Asset Managers, which manages some 450 million pounds, s aid he had been adding to equity positions such as UK retailer Kingfisher recently at the expense of bonds.
A relatively attractive price of around 12 times projected earnings and a 4 percent dividend yield, were among the measures used by some to justify fresh purchases.
"These are good fundamental reasons to hold equities and if you can handle the volatility in the short term, you will find a lot of value in equities," said Kristian Falnes, global equities portfolio manager at SKAGEN, which manages around 11 billion pounds ($17 billion) of a ssets in value equities strategies.
Falnes said he favoured German industrial conglomerate Siemens and HeidelbergCement for their exposure to emerging market growth and balance sheet strength.
The wide gap between the expected earnings per share (EPS) of developed European corporates over the next five years based on company estimates and that implied by current share prices also lends support to value-hunters.
The combined five-year forward EPS compound annual growth rate - the amount they are forecast to return yearly over that period based on past performance - is 6.6 percent, Thomson Reuters StarMine data showed. The market, however, is currently pricing in a yearly contraction of 4.2 percent.
With the return from "safer" government bonds and cash, yielding around 2 percent and zero, respectively, so low, some buyers are dipping their toes back into equities in spite of the region's economic and political uncertainty.
The euro area just avoided recession in the first quarter but purchasing manager data on Thursday showed even core states such as Germany and France were being caught in the downturn.
"While it may seem wildly optimistic, we continue to believe that growth, albeit anaemic, is on an improving trajectory and that equity valuations are attractive - particularly in comparison to bonds," Neil Veitch, fund manager at SVM UK Opportunities fund, said.