* Australia's sovereign wealth fund increases risk exposure
* Fund returns 8.8 percent, beating yearly target return
* Fund says it will be cautious in the longer term
By Paulina Duran
SYDNEY, Feb 1 (Reuters) - Australia's A$139 billion ($112 billion) sovereign wealth fund on Thursday said it beat its target return in the year to December by increasing its bet on global equities and reducing its cash holdings.
The Future Fund, which was set up in 2006 to cover escalating pension liabilities for public servants, posted an 8.8 percent return for the 12-month period, beating its 6.4 percent target.
The Melbourne-based fund is upbeat about global growth, while also highlighting economic challenges posed by leverage and disruption.
"Given the positive near-term outlook we have modestly increased the fund's risk levels," Future Fund Chairman Peter Costello said in a statement on Thursday.
The fund's allocation to global developed equities increased 2.3 percentage points to 19.6 percent in the December quarter, mainly at the expense of its cash allocation, which was down 2.5 percentage points.
The strategy helped boost performance for the quarter to 3.3 percent, up from only 0.8 percent the previous quarter, Chief Executive David Neal said at a media briefing. fund had been prepared to take risk given the current improved global growth setting. However, it said there were longer term reasons to be cautious, as central banks around the world end their expansionary monetary policies.
"As interest rates around world rise towards more normal levels, we expect to see downward pressure on asset prices. Our strategy is designed to allow us to benefit from stronger markets while avoiding excessive risk," he said.
The Future Fund was set up just over a decade ago with contributions of A$60.5 billion from government surpluses and the proceeds of the privatisation of the national telecommunications operator Telstra Corporation Ltd TLS.AX .
It seeks to achieve returns of 4 percent to 5 percent above inflation. ($1 = 1.2407 Australian dollars)