AT&T Wireless: Playing the Index Card

On Friday, investors will have to decide whether to exchange their shares of AT&T (T Quote) for shares of the AT&T Wireless (AWE Quote) tracking stock. When the big index funds decide, it will move the market.

In the exchange offer that expires Friday, AT&T will accept up to 427 million T shares, exchanging each one for 1.176 shares of AT&T Wireless. If the offer is fully subscribed, then AT&T's holdings of AT&T Wireless will fall from about 70% today to just below 50%. Then in midsummer, AT&T will distribute its remaining AT&T Wireless shares to all T shareholders, and AT&T Wireless will convert from a tracking stock to a regular stock.

What to Do?

Should you exchange your AT&T shares for the AT&T Wireless shares Friday? Well, if it helps, I can tell you that on our trading desk we refer to AT&T Wireless as "AT&T Worthless." But then we don't exactly love the parent company, either. So for us, Friday's offer is little more than the opportunity to exchange a frying pan for a fire.

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If you manage some of the $1 trillion indexed to the S&P 500, the decision is pretty much already made for you. You don't want to exchange your AT&T shares for AT&T Wireless shares because AT&T Wireless isn't a member of the S&P 500 -- and probably isn't going to be anointed one by Friday.

But that doesn't mean the indexers will do nothing Friday. Because the exchange offer will effectively extinguish shares of AT&T, its market capitalization will go down -- so indexers will have to hold less of it in order to track their capitalization-weighted benchmark.

Right now, AT&T's index weight is about 0.74%, and after Friday it will be 0.65%. That means indexers will have to sell about 38 million shares market-on-close Friday, and redistribute the proceeds across the other 499 stocks in the index. The market value of that trade is about $839 million on each side.

Complications

There are two potentially complicating factors.

First, since the exchange offer was announced, AT&T has traded at a discount to AT&T Wireless. In other words, the value of a share of T was less than the value of the 1.176 shares of AWE for which it could be exchanged. I've seen the discount as high as 9%, but today it's closer to 2%. Many arbitragers have tried to take advantage of this by buying T and simultaneously shorting AWE, planning to tender on Friday to unwind the trade at a profit.

The risk in that trade for the arbs is that they don't know how fully the exchange offer will be subscribed. If it's oversubscribed, they won't get all their AT&T shares exchanged for AT&T Wireless shares, and on Monday morning they'll be scrambling to sell AT&T and buy back AT&T Wireless. Some have hedged with options, but that doesn't make the risk go away -- it just transfers it to someone else who will have to do the scrambling.

If AT&T Wireless is still at a discount Friday, perhaps the more aggressive indexers will short AWE instead of selling T at the close, and then tender their T shares to cover the short. This would eliminate a little bit of the direct selling pressure on AT&T. But I don't expect much of this. The discount is steadily narrowing to zero, but the risk of not knowing how many tendered shares will be exchanged remains just as great.

The second potential complication is that Standard & Poor's just might anoint AT&T Wireless as an S&P 500 index member Friday. If that happens, indexers will still sell their T shares, but they'll need to replace them with shares of AT&T Wireless instead of with shares of the other 499 stocks.

Exchanging their AT&T shares for AT&T Wireless is an imperfect solution because they don't know how many of the shares they tender will actually be exchanged. But even if they were all exchanged, indexers would still be buyers of AT&T Wireless -- because the fraction of AT&T Wireless' market capitalization represented by the exchange is only 20% of its total capitalization. So indexers would need to buy about four times as much AT&T Wireless market-on-close Friday as they would get, at maximum, in the exchange offer.

That means they'd be net sellers not only of AT&T, but also of the other 499 stocks in the index as well, in order to raise the money to buy the extra AT&T Wireless shares they'll need. But remember, it only plays that way if S&P adds AT&T Wireless to the index. Odds are that S&P won't do that -- so the indexers will be sellers of T and buyers of the other 499 index stocks, size by large.

I have no idea whether this event will be exploitable by speculators who try to make a quick buck off the indexers by, in essence, front-running their predictable market-on-close orders. The indexers and the brokers who take execution risk for them aren't stupid -- so be careful if you go up against them in this highly liquid name in this highly publicized transaction.