* Posts record 22.2% return in year to June 30

* Ups listed stocks allocation to 35.8%, highest level since 2019

* Conditions all there for a sustained increase in inflation - CEO

SYDNEY, Aug 26 (Reuters) - Australia's sovereign wealth fund on Thursday said it had achieved its highest return on record after betting on global stocks and private equity, and was moving to safeguard against inflation as the world recovers from the COVID-19 pandemic.

The Future Fund said its flagship A$196 billion ($143 billion) portfolio achieved a record 22.2% return in the financial year to June 30, smashing its target of 5.6% and last year's negative 0.9% return.

Over the latest quarter, the Fund said it reduced its cash holdings by nearly a third to buy Australian and globally listed stocks, as well as to increase its private equity holdings and invest directly in infrastructure assets.

"Over the medium-term, returns are going to be harder to produce," said Chief Executive Officer Raphael Arndt. "Reducing some flexibility to move to a modestly higher level of risk is appropriate."

Established in 2006 to cover escalating pension liabilities for public servants, the Future Fund has more than tripled in size since then, despite having no investment contributions since 2007.

It is now seeking to protect its portfolio against inflation.

"We're not saying we think it's extremely likely, or that it's happening anytime soon. We don't know, but certainly the conditions are all there for a sustained increase in inflation," Arndt told reporters in a call.

"And that is very, very damaging for investment returns when you're starting at a point where real interest rates are negative."

The fund's allocation to equities increased by 3.7 percentage points to 35.8% during the three months to June 30, its highest since September 2019.

The fund was avoiding companies with high valuation multiples that "aren't generating any profits", prioritising profitable firms whose margins are protected, such as those in the consumer staples sector.

It will, over time, also increase its focus on less liquid "skill-based" opportunities where its investment managers can create value, Arndt said.

The fund, ranked No.1 https://www.reuters.com/world/americas/australias-future-fund-tops-governance-ranking-sovereign-investors-2021-07-01 globally among sovereign investors for its sustainability, governance and resilience, was part of a consortium earlier this year that bought https://www.reuters.com/article/tilt-renewables-ma-mercury-nz-idUSL4N2M927Y Tilt Renewables and another that bought telecommunication towers from Telstra Corp.

It has been identified by sell-side analysts as a potential suitor of the operator of Australia's largest airport, Sydney Airport Holdings Pty Ltd, which recently rejected a A$22.26 billion takeover offer.

When asked on Thursday, the fund declined to comment, but noted it has invested in the asset class before.

Cash holdings fell by 5.4 percentage points in the past quarter to sit at 13.2%. Over the past decade, the fund achieved an average return of 10.1%, exceeding its 10-year benchmark of 6.1%, it said.

($1 = 1.3749 Australian dollars) (Reporting by Paulina Duran in Sydney; editing by Richard Pullin and Lincoln Feast.)