NEW YORK, July 12 (Reuters) - Former U.S. Securities and Exchange Commission Chairman Harvey Pitt on Wednesday said the hedge fund industry should take a more active role in the debate over hedge fund regulation -- or face rules imposed by state regulators.

Pitt, who was SEC chairman from 2001-2003, told an industry audience that "it was a bad idea" for the SEC to force many hedge funds to register as investment advisors.

But Pitt said the industry's recent victory in federal court in Washington, D.C., vacating the rule "may prove to be worse for the hedge fund industry."

"It leaves people like Eliot Spitzer and Richard Blumenthal (state attorney generals for New York and Connecticut) to take steps," said Pitt. "This could be far worse than SEC regulation."

Pitt, who had spearheaded a move to examine hedge fund trading practices at the SEC, said hedge funds are increasingly looking to higher-risk strategies to generate returns in a ballooning industry.

These include investing in such instruments as derivatives, second-lien loans, asset-backed securities, bridge loans and others, he said.

At the same time, hedge funds, which are estimated to number 8,500 with $1.3 trillion under management, are increasingly attracting ordinary investors through public and corporate pension plans, said Pitt.

"Funds are growing riskier at the same time that people investing in them have become more risk averse," said Pitt. Small investors, he said, "have absolutely no business being in risky hedge funds."

Pitt's comments before an industry forum sponsored by Strategic Research Institute come as the SEC is weighing its regulatory approach to hedge funds in the wake of federal appeals court ruling in June.

Pitt, now CEO of consulting firm Kalorama Partners, didn't outline what approach the industry should take in dealing with regulators. But others, including prominent hedge fund manager Jim Chanos, have said the industry should be more proactive in addressing regulatory and legislative concern about hedge funds.