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* Absence of rupee risk, local market knowledge to helpdomestic funds * High fees, distribution costs to be a challenge fordomestic funds * Ten local hedge funds operating under new structure set upby regulator By Subhadip Sircar and Rafael Nam MUMBAI, April 29 (Reuters) - Indian hedge fund managerKalpesh Kinariwala is so sure of his equity strategies in acountry that has stumped foreign rivals that he sends a dailye-mail tracker of his performance - including to competitors. Kinariwala's Capveda Capital (India) Advisory fund, which heruns from a modest office in a decrepit industrial estate inMumbai, has returned 11.86 percent so far this year,outperforming average negative returns of 2 percent fromIndia-focused foreign hedge funds. Local hedge funds are eager to show off double-digit returnsin the hopes of drawing wealthy Indians and succeeding whereoverseas players including HSBC Holdings PLC havefailed. Local market knowledge and the lack of foreign currencyexposure will favour domestic funds, but it remains to be seenwhether Indians would embrace new investment styles in a countrythat traditionally prefers buying and holding stocks. "It will be very difficult," said Samir Arora, founder ofSingapore-based Helios Capital, which manages hedge fundsfocused on India. "India is a small market, and hedge funds will have to showexperience shorting, and they will have to appeal to a high networth crowd, requiring (costly) distributors," said Arora, whoshut one of his India-focused funds called "Jai Ho," named afterthe Oscar-winning theme song from Slumdog Millionaire in 2011. Investing approaches such as an equity long-short strategyare still a novelty in India, making it harder for hedge fundmanagers to attract local wealthy individuals. To raise the bar even more, domestic investors are not usedto the high fees commanded in the hedge fund industry. Funds also face a high success threshold in a country whereplain vanilla bank deposits offer nearly double-digit returns,with consumer price inflation of around 10 percent. Costs are another challenge. To reach wealthy investors, funds are relying ondistributors with deep rolodexes who don't come cheap, chargingcommissions of 25-30 percent of gross earnings in the first fewyears. In light of the challenges - on top of an unruly rupee -overseas hedge funds have retreated from India over the last fewyears. Assets under management for overseas hedge funds focused onIndia have shrunk by 68 percent from 2007 to $2.1 billion inMarch, according to data from Eurekahedge. The data also shows India-focused foreign funds returned12.3 percent last year - a period when the rupee waswhipsawed by economic worries - well under the 25.7 percent gainin the broader BSE share index. HSBC was among the casualties, shutting its India-focusedfund run by high-profile manager Singapore-based Sanjiv Duggalearlier this year after cash withdrawals from investors. START SMALL India's regulators have formally approved 10 domestic hedgefunds since last year under new rules aimed at organising theindustry. Overseas funds are not regulated. Local funds are planning to start small. The average size of funds is expected to be around 1-2billion rupees ($18-$36 million), according to industry players. They are targeting wealthy individuals and corporations, whomust be convinced to pay the industry standard fees of 1.5-2percent for management and 15-20 percent of profits, high byIndian standards. "We will be very selective, probably reject nine out of 10strategies," said Himanshu Kohli, co-founder of ClientAssociates, which advises individuals and families on wealthmanagement. "Wealth creation is a relatively young process in India. Thebiggest concern for investors is to protect their capital," hesaid. Local hedge fund managers are betting that a vibrant stockfutures market would make it easier to undertake shortingstrategies. Average daily futures and options volumes on the NationalStock Exchange have nearly tripled to 1.32 trillion rupees fromfour years ago. However, not all stocks can be traded in thederivatives segment. Perhaps the biggest potential cost headache is taxation,given the lack of clarity on whether capital gains duties are tobe borne by the fund or by the investor. Kinariwala, who is waiting for formal approval of his fundunder the regulator's reorganisation, is not bothered. He is targeting returns of 18-24 percent, more than doublethe 7.8 percent yield offered by the 10-year government bond, and says his performance will convinceinvestors of the merits of his trading models that he bases onmonitoring market momentum. "If somebody is demonstrating a good track record, the skyis the limit," said Vaibhav Sanghavi, who heads a long-shortfund at Mumbai-based financial group Ambit Capital, whichreceived a hedge fund license this month.