Reserve Chair Kevin Warsh wasn't nominated to raise rates, but he did so anyway. Now, cash investors are asking why money market fund yields have lagged. The answer is mechanics, not malfunction.

Warsh and his colleagues on the Federal Open Market Committee (FOMC) may have felt pressure from the White House, the bond market and price-conscious consumers to keep interest rates steady, but they ultimately had to acquiesce to data showing that the economy was healthy enough to sustain inflation above the 2% target. They had little choice last month but to lift the band to 3.75-4.00%.

You must give Warsh credit — it wasn't the outcome many expected from him, but he did what the data demanded.

Against that backdrop of rising rates, you might have expected capital to flood into money market funds (MMFs). But, in fact, total MMF assets decreased by $45.45 billion to $7.89 trillion, as of the week ending September 30, according to the Investment Company Institute (ICI).

This reflects the fact that not all cash-like instruments reprice at the same speed. It is true that when the Fed raises its policy rate, yields across overnight markets, government auctions and floating-rate securities can adjust almost immediately. Yet the yield on a money market fund usually takes longer to catch up.

But this lag and the logical investors' response are not signs that the market is malfunctioning or losing favor with investors. Rather, they are a normal consequence of how these portfolios are constructed.

Repurchase agreement (repo) rates and other instruments closely linked to the federal funds rate can reset almost immediately because they are overnight rates tied directly to the federal funds target range.

A money market fund works differently, however. Rather than simply tracking an overnight rate, a fund owns a diversified portfolio of short-term securities purchased at different points in time and with different maturity dates. Some holdings may mature tomorrow; others in several weeks or months. This is referred to as the "laddered strategy." When the Fed raises rates, the existing securities held by MMFs do not suddenly start paying the new, higher market yield. That process takes time. Instead, as they mature, the fund reinvests the proceeds in newly issued securities offering rates that reflect the now higher-rate environment.

Depending on the portfolio's weighted-average maturity and market conditions, it can take roughly three to four weeks for a rate increase to work its way through to an MMF's yield. The fund is effectively climbing a ladder, or a staircase if you will, rather than shooting to the top in an elevator.

This also explains why the same mechanism operates in reverse. If the Fed cuts rates, overnight instruments reprice downwards quickly, while an MMF may continue to benefit, in some cases for weeks, from securities previously purchased at higher yields. That can make MMFs attractive to investors and helps explain why they can attract short-term inflows after a rate cut.

Today's higher-rate environment provides institutional investors with a much broader range of attractive places to maintain liquidity. MMFs and other cash-like instruments, such as Treasury bills and direct repo, can let treasurers seeking certain liquidity requirements spread exposure across a wide range of high-quality issuers, rather than just relying on one or two.

In an era where cash very much has a place in portfolios in an active sense, the question now is where exactly that cash should sit.

An overnight deposit may offer operational simplicity, but it also creates exposure to a particular bank. Direct repo can provide an attractive rate and high-quality collateral but requires the infrastructure and expertise to transact and manage those positions. Treasury bills provide direct exposure to US government securities but require investors to manage maturities and reinvestment themselves.

When interest rates were close to zero, the differences between many cash instruments could feel relatively inconsequential. Cash itself was frequently viewed as a temporary parking place, something investors held while waiting to put capital to work elsewhere. Higher rates have changed that, and investors are being compensated meaningfully for liquidity.

But having higher and more variable rates also means that the relative value available across the short end of the curve can move quickly. The challenge now is to keep up.