* Real estate growing at expense of fixed income
* Investors miss target returns by 2 percentage points
* UK suffers big year-on-year drop in attractiveness
LONDON, June 5 (Reuters) - Sovereign investors are raising their property exposure at the expense of low-yielding bonds in an attempt to boost returns, but Brexit is seen as a significant negative for all UK investments, a study by asset manager Invesco showed.
The annual report, published on Monday and based on interviews with 97 sovereign wealth funds, state pension funds and central banks with assets in excess of $12 trillion, found sovereign investors underperformed their target returns by 2 percentage points on average over the past year.
What Invesco defines as "investment sovereigns," which have long time horizons and higher return targets, fell short by 3.7 percentage points, and "development sovereigns," which encourage domestic growth, underperformed by 3.1 percentage points.
Governments are also paying less into the funds -- on average, the equivalent of 5 percent of assets under management in 2017, down from 8 percent in 2015. This is forcing investors to seek out higher yielding assets such as high grade office and commercial real estate.
Over two-thirds of sovereigns were overweight global real estate in 2016 and 46 percent expect to be overweight again this year. Safe-haven markets such as North America and Western Europe were preferred.
Exposure to home market real estate is also growing, particularly amongst Western and Asian sovereign investors, due to the depth of the local markets. Home markets are seen as more familiar and accessible.
New property investments are mainly funded out of fixed income holdings, with 48 percent of respondents citing this.
The focus on real estate is partly driven by the fact that accessing other illiquid assets, such as infrastructure and private equity, remains difficult.
Deploying money into infrastructure is now expected to take four years, up from 3.5 years in 2016's survey. Real estate is unchanged at two years.
"One of the reasons for low returns is they are still underweight their target allocations," said Alex Millar, head of EMEA sovereigns at Invesco.
Some 71 percent of sovereigns are underweight their infrastructure allocation, which means growing levels of undeployed capital held in cash and money market funds: "It's a cash drag, a non-allocation drag," said Millar.
He added real estate was attractive because it generates income in the form of rents, which is helpful for sovereign investors suffering reduced funding from their governments.
The study was carried out between January and March 2017 and also reflects investor anxieties about Brexit. The UK saw the biggest drop in attractiveness, scoring 5.5 out of 10 versus 7.5 last year.
Invesco said investment sovereigns with European interests had questioned the future of the UK as an investment hub for Europe, given the uncertainty over taxes on imports and market access posed by Brexit.
"You've got this multiple-year uncertainty," Millar said. "Some people said it was a buying opportunity, others are a bit more cautious. Where traditionally they might have used the UK as a gateway for their European investments, now they are looking a bit more at Germany."
Some 41 percent of sovereigns expect to introduce new underweight positions to the UK in 2017, compared with just 5 percent planning new overweight positions. A majority of 54 percent said they wouldn't make any changes to their weighting, preferring to wait to assess the longer term impact of Brexit.
The United States remains the most attractive market, scoring 8 out of 10, with 37 percent of respondents reporting they were overweight new flows to North America in 2016 relative to their total portfolio -- higher than any other region. A net 40 percent plan to overweight further in 2017.
Millar said the attractiveness was driven by interest rate rises, pro-business tax reforms and potential infrastructure spending following Donald Trump's election as president. But he added protectionism remained a concern: "People are aware of that rhetoric but they are watching for policy actions."
Emerging markets also improved, scoring 5.7 out of 10, up from 5.2 last year. But whilst Russia, China and India all scored higher year-on-year, Brazil was seen as less attractive, slipping to 5.4 from 5.6 last year. (Editing by Catherine Evans)