* Demand for European equity fund picks up
* Long-term buyers look beyond Cyprus crisis, Italy deadlock
* Annual returns of 7-9 pct targeted over 3-5 years
By Francesco Canepa
LONDON, April 9 (Reuters) - Long-term investors are tiptoeing back into European shares after a five-year exodus, expecting annual returns of 7-9 percent and bringing in billions of euros that should drive the market higher.
While it is too early to talk of a major shift into shares from bonds, where long-term buyers are primarily invested, demand for European equity funds has picked up since late 2012, spurred by central bank action to stem the financial crisis.
This support has allowed long-term buyers to look beyond obstacles such as the Cyprus crisis and mixed economic data and buy dips in equity markets, pushing the MSCI Europe index to a 4-1/2 year-high in March.
These new buyers, especially retail clients burned by the financial crisis in 2008, sat out equity rallies in 2009 and 2012, Lipper funds data showed.
Their return to stocks, after halving their exposure since 2008, would be a very positive signal and, due to their large firepower, could be a major market driver in the coming years.
A return to economic growth in the euro zone - expected towards the end of the year - would probably see the buying momentum accelerate.
"This market is driven by investment flows, which are totally favourable to equities at the moment, boosted in part by central bank liquidity," Xavier Lespinas, head of equities at SwissLife Banque Privee, which has 3.2 billion euros ($4.11 billion) in assets under management.
European funds invested in the region's equities recorded their largest monthly net inflow in five years in January, the latest month for which Lipper data is available, extending a positive trend started when the European Central Bank pledged to help struggling countries in September.
But, at 318 billion euros, their assets are still just 60 percent of their 2007 peak, leaving scope for further growth.
This is even truer for U.S. funds invested in European shares, which have assets equal to a seventh of their end-2007 level, even after three consecutive quarters of net inflows.
The new money has chiefly come from high cash reserves and, to a much lesser extent, government debt as bond-buying programmes from central banks drove down yields and pushed returns on cash into negative territory.
The expected annual return on European shares, measured by their dividend yield, is 3.6 percent this year, compared with a 1.3 percent yield on German 10-year bonds, Reuters data showed.
"You have to come back to riskier assets if you want to maintain the expected returns that you have as a target," said Mouhammed Choukeir, chief investment officer at Kleinwort Benson, who has been adding to his equity holding this year.
"You could see annualised returns of about 7 or 8 percent over the next few years although it's going to be bumpy along the way."
The average return on the pan-European MSCI Europe index since 2002 is 5.5 percent, Datastream data showed, so a 7 percent return would represent a 27 percent outperformance compared with the index's recent history.
Since the turn of the year, each time the MSCI Europe index has fallen more than 1.5 percent in a session, buyers have come in and the index has cut its losses by the market close.
Among the dip-buyers was Didier Duret, chief investment officer at ABN-AMRO Private Banking in Geneva, who manages some 170 billion euros and is targeting annual returns of 7-9 percent in the next three to five years on his equity investments.
He said private and institutional clients who had largely missed out on a market surge in the second half of last year had finally grown more confident that the darkest hour of the euro zone crisis was passed.
"We're seeing a lot of requests from clients that want to put in place equity portfolios not based on the short-term momentum considerations but for...three to five years," he said.
Global insurers and pension funds, with combined firepower of $59 trillion, according to Deutsche Bank, are also considering boosting their equity holdings, albeit more slowly.
"There is a block of investors who are taking long-term views on the market again," said Andrew Milligan, head of global strategy at Standard Life Investments, who has increased the share of equities in his 160 billion pound ($242.06 billion) portfolio to about a third of in recent months. He expects annual returns of up to 9.5 percent over the next 10 years.
"It's a slow evolution of how some pension funds are repositioning themselves, but it's far from being anything dramatic and quick."