* Improved data lures investors back
* Flows into Italy, Spain ETFs outpace Europe - ETFGI
* Lipper data shows room to grow further
* Recent market wobbles show political risk a concern
By Francesco Canepa
LONDON, Aug 27 (Reuters) - Investment in Spanish and Italian stocks has surged on the back of improved economic data, trumping a Spanish party funding scandal and the risk that the government in Rome could fall.
Investors have given both countries a wide berth for years but are being lured back by rosier survey data and the end of the recession in the euro zone.
Signs of economic revival have helped lower both countries' borrowing costs and drawn money into Italy-focused funds at the fastest rate for a decade, EPFR data showed. Italian and Spanish exchange-traded funds took in more money in July than in the entire second quarter.
Their benchmark stock indexes are up accordingly; Italy's FTSE MIB is on course for its best quarter since late 2009, and Spain's IBEX 35 for its best since late 2010.
The two indexes are a direct way to profit from a pick-up in the euro zone periphery, they have a greater proportion of firms focused on Europe than their euro zone peers at a time when many strategists recommend increasing exposure to the continent, and are cheaper than euro zone alternatives, such as French stocks.
For some, such as M.M. Warburg market strategist Matthias Thiel, now is the time to buy in as he believes the better economic prospects outweigh the risk of new political tensions.
"The view of many investors concerning those equity markets is still negative, despite the fact that the economy is getting better. And then they are quite attractively valued. We see that risks remain, but we think they are in the price already."
Over the past 10 days, renewed fears that former premier Silvio Berlusconi's People of Freedom (PDL) party could bring down the government in Rome shaved 5.7 percent off the FTSE MIB and drove up the cost of buying options to insure against future swings in the index by around 15 percent.
Italy's ability to keep investors on side will be tested next month; the PDL has said it will withdraw from the fragile coalition if parliament votes to remove Berlusconi, recently convicted of tax fraud, from the Senate.
In Madrid Prime Minister Mariano Rajoy has survived calls to resign for mishandling a major corruption scandal involving his party's former treasurer.
"If we had a return to the polls in Italy, the fall in borrowing costs that we've seen in the past few months would be reversed, and the equity index would easily drop 10 percent, and the same applies to the IBEX," said Claudia Panseri global equity strategist at Societe Generale Private Banking, which manages just under 90 billion euros ($120 billion) of assets.
"In the longer run, which is more like 12-24 months, it is obvious Italy and Spain are attractive if the reform process continues."
After lagging for most of the previous five years, Italian and Spanish ETFs have outpaced inflows into funds tracking the broader European market by more than seven times since the start of the year, ETFGI data showed. ETFs can be bought and sold more quickly than traditional funds and are often used by hedge funds.
While monthly ETF flow data is not a reliable gauge of future market direction on its own, low valuations and light investor positioning leave ample room for more money from longer-term investors to return.
While overall European equity funds' assets are up from their levels at the end of 2009, before the euro zone crisis began, the total assets of funds invested in Italian and Spanish shares are still down 11-12 percent, Lipper data shows.
The FTSE MIB and IBEX 35 remain roughly 50 percent and 40 percent off their 2008 peaks, respectively, while the broad STOXX Europe 600 is only down about 10 percent.
Spain and Italy roughly trade at a 10-20 percent discount to the regional index, based on the expected earnings of their constituents over the next 12 months, Datastream data showed.
Part of that gap is due to banks, which account for around a third of both indexes and are the most vulnerable stocks to any sign of a rise in the countries' borrowing costs through their large sovereign debt holdings.
Conversely, they have performed well this quarter as the spread of both countries' benchmark debt to safe-haven German Bunds narrowed to their tightest levels for two years.
The flow of money from emerging markets into Europe, and especially into cheaper stocks more reliant on sales in the region, such as banks, has also helped both outperform more internationally focused peers such as Britain's FTSE.
"They are the riskier markets, but there is probably more potential there," said Kerry Craig, global market strategist at JP Morgan Asset Management, which manages assets worth $1.5 trillion. "As confidence and business picks up there, as you can see from the economic indicators, you should see these markets perform much better."