Wall Street is emerging with a new tax alpha business: helping American billionaires generate losses to defer taxes.

Why is Tax Alpha Strategy Attracting Over a Trillion Dollars in Funding?

David Hauser loves index investing and almost doesn’t believe that professional fund managers can bet on “winners” with his money. But he firmly believes that these people can at least identify some “losers.” Therefore, he just handed over about $5 million to a quantitative stock selection strategy—what they promised to do is precisely “create losses.”

Unlike most active strategies, the strategy chosen by Hauser aims not just for alpha, which is excess returns that beat the market. It also pursues what is known as “tax alpha”—the “returns” achieved by reducing tax liabilities, which in some cases can be even more valuable. The strategy aims to make money overall while simultaneously taking long and short positions in different stocks, hoping to generate losses that can offset capital gains, thus reducing the taxes this entrepreneur owes to the government.

“I thought at the time, it’s impossible to do this without taking on significant risk,” Hauser, who lives in Las Vegas, recalls when he first saw the promotional materials. “But after digging deeper, I found the risk characteristics acceptable to me.”

Hauser’s investment strategy is part of a burgeoning trading ecosystem. As the market has continued to rise over the years and taxable gains have accumulated, Wall Street is racing to help America’s wealthy cope with tax burdens. Currently, over a trillion dollars is invested in various tax optimization strategies, spanning hedge funds, exchange-traded funds (ETFs), and individual accounts.

Since every dollar saved in taxes by investors means one less dollar collected by the government, the explosive growth of this industry has raised alarms in some circles—especially against the backdrop of widening wealth inequality and rising fiscal deficits. The U.S. Treasury is preparing to strengthen scrutiny on at least one of these strategies. However, critics argue that officials need to do more to curb these practices; meanwhile, these strategies also expose investors to new risks.

Despite this, wealthy Americans are flocking to them. In an era where passive funds and low-fee ETFs have siphoned off most of the capital, this wave of “tax alpha” is bringing new revenue sources to the asset management industry and providing a path to regain market attention.

“Tax alpha is the most stable source of excess performance you can realize,” says Samuel Harnisch, founder of Quantitative Financial Strategies, based in Denver, which focuses on serving taxable high-net-worth clients.

Tax alpha strategies vary widely in objectives, complexity, and aggressiveness. On the “milder” end are so-called “non-distributing” ETFs: by timing sales of stocks to avoid generating capital distributions, they reduce taxable income for the fund. On the “more aggressive” end are specialized hedge fund products that create deductible expenses to offset investment income or even wage income.

According to Brent Sullivan, a widely followed tax blogger, strategies like the “tax-aware long-short” that Hauser employs currently attract over $10 billion in funding.

In the hedge fund space, the pursuit of “tax alpha” is reaching a peak. Hedge funds historically didn’t focus much on taxes because their primary clients, such as pension funds and endowment funds, are usually tax-exempt. However, in light of surging demand from other investors, many institutions are modifying existing strategies to fit this new market.

A recent paper by Columbia Business School assistant professor Federico Mainardi found that, compared to less wealthy families, the wealthiest Americans have a smaller share of realized gains and more realized losses, especially when using private banking services. He estimates that without such tax alpha, the wealth share of the top 1% would increase by 3.5 percentage points less over the next 30 years.

“Just wealth alone is insufficient to explain the differences in your realized gains and losses,” Mainardi says. “The real key is the combination of wealth with a complex, specialized financial advisory system, especially private banking.”

The rapid expansion of the tax optimization ecosystem has naturally attracted significant criticism. Opponents argue that reducing the tax burden on the wealthy at the expense of public revenue is ethically indefensible, especially when the biggest beneficiaries are often the wealthiest, further exacerbating inequality.

One reason many strategies have become possible or more widespread is that technological advancements have far outpaced the tax law frameworks established decades ago.

“Financial engineering is only going to get more sophisticated,” says Steve Rosenthal, a former partner at Ropes & Gray LLP and a former legislative advisor to the U.S. Congressional Joint Committee on Taxation. “Computers are bigger and more powerful, and AI is right around the corner. We have an outdated tax system that is struggling to keep up with the flexibility that modern financial engineering offers.”

Many tax optimization strategies on Wall Street emphasize “deferral” rather than “avoidance” of taxes. Therefore, when investors eventually liquidate their portfolios, they still need to pay taxes on the profits accumulated since the initial investment.

This is also why tax alpha has become a cash cow for the asset management industry: it often “locks” clients into the schemes since exiting can trigger a tax bill.

Deferral strategies are particularly “advantageous” if investors plan to retire, move into a lower tax bracket, or relocate to states with lower tax burdens in the future. The ultimate tax efficiency play is to extend deferral until death: at that point, U.S. tax law resets the “cost basis” of securities, or their purchase price, creating significant tax advantages for asset inheritance.

Hauser firmly believes he knows how to spend his money better than the government, which is why he has done considerable optimization regarding estate taxes after his death.

The 43-year-old father of three says, “I’m saving taxes on things I might never realize—that’s the ultimate deferral.”