It isn’t just Chinese politics that pension managers are worried about. A large Midwestern pension fund opted against several investments in Chinese private debt in 2019 and 2020 because investment managers worried they might have to sell at a loss if state or federal lawmakers added new restrictions on Chinese investment, according to a person familiar with the matter.

This divergence has been years in the making, fund managers and pension executives say. Culprits include rising political discord between the U.S. and China, as seen in the sudden halt of Ant Group’s initial public offering two years ago and a ban on for-profit tutoring last year. Accentuating these concerns has been the rise of inflation in 2022 and the possibility of military conflict between China and Taiwan, fund managers say, along with the global rout in Chinese shares after President

Xi Jinping

cemented political control.  

“Anytime you see the types of drawdowns that we’ve been seeing in China, you have to be concerned,” said North Carolina Treasurer Dale Folwell, who oversees the state’s $110 billion pension fund. China stocks in the fund had a market value of $1.27 billion on Wednesday, down from $1.51 billion on Sept. 30.

The state and local officials who manage about $5 trillion in retirement savings for teachers, firefighters and other public workers have increasingly turned to China over the past two decades as they seek to plug funding shortfalls. Big state public pension funds invest billions of dollars in Chinese private equity, venture capital and real estate. At a range of state and city pension funds across the country, Chinese stocks make up an increasing share of international or emerging-markets equity portfolios. 

An average 7% of public pension funds are invested in emerging-markets equities, up from 3% in 2001, according to Boston College Center for Retirement Research data on funds that report that level of detail. Pension managers typically try to match or beat international indexes where China makes up around 10% or more. They tend to buy stock in all the countries represented because if one sees major gains, they don’t want to miss out and underperform the benchmark. 

Investment staff at the nation’s largest pension fund, the $430 billion California Public Employees’ Retirement System, spend “quite a bit of time” trying to navigate Chinese markets,

Dan Bienvenue,

then interim investment chief, said at a meeting last fall. The fund has a total of $11 billion invested in China across all asset classes, as of June 30, 2021. That includes public and private equity and real assets, a category that includes buildings and land.  

Calpers last year reported holdings in

New Oriental Education & Technology Group Inc.,

TAL Education Group

and

Gaotu Techedu Inc.,

companies hurt by the crackdown on for-profit education. The $290 billion California State Teachers’ Retirement System, the second-largest fund, had some limited exposure through its private-equity holdings to Ant Group before the government crackdown.

Both funds, like many public pensions, have reported holdings in

Alibaba,

Baidu,

JD.com,

Pinduoduo

and

NetEase.

U.S.-listed Chinese stocks lost tens of billions of dollars in market value this past week after falling to their lowest level in almost a decade. The Nasdaq Golden Dragon China Index, which tracks dozens of Chinese companies listed on American exchanges, has lost more than 10% since Oct. 21. Hong Kong’s main benchmark Hang Seng Index was down 8.3% for the week.

Moves such as the California teachers fund’s bid to hire China stock managers are less common, pension consultants said. A person familiar with the fund, known as Calstrs, said the action is part of a broader strategy of geographical diversification when returns in Europe and the U.S. are slowing. 

The board of the $183 billion Teacher Retirement System of Texas, meanwhile, voted last month to cut its target China stock allocation to about 1.5% of the fund from 3%. Pension officials cited a goal of increased diversification in the emerging-markets portfolio, where China stocks had grown to a little more than one-third of total holdings.

The new allocation, which is expected to take six months to implement, will see China’s target weight falling slightly below that of Taiwan. In a memo last month, the fund emphasized that it has the ability to scale back its Chinese investments “in accordance with its own economic and political analysis.”

The Texas fund also scrapped plans to open a Singapore office about three years ago. Officials had determined the fund could manage regional assets effectively from Austin, investment chief Jase Auby said. 

Some pension officials grew more skittish about emerging markets after Russia invaded Ukraine in late February. Some retirement funds around the world who tried to pull money from Russia found their assets were frozen or lacked buyers.  

In the wake of the Ukraine invasion, Florida’s $182 billion pension fund halted new investment strategies in emerging markets, including China, according to a transcript of comments by State Board of Administration interim chief investment officer Lamar Taylor at a March trustees meeting.  

Mr. Taylor cited several factors, including stress in the Chinese property market, and “the government’s somewhat erratic responses” in the tech sector and the for-profit education sector. He said in an August letter to the board’s investment advisory council that China’s refusal to condemn the Russian invasion and the two countries’ continued alliance could affect the value of Florida’s China investments.

Despite the many risks associated with investments of all sorts right now, Mr. Folwell of North Carolina said his fund isn’t planning any changes to its China allocation. “It’s the second-largest economy in the world,” he said.

Write to Heather Gillers at heather.gillers@wsj.com and Michelle Chan at michelle.chan@wsj.com