NEW YORK (CNN/Money) - Are hedge funds secretive schemes that need to be regulated or smart investments designed for sophisticated investors who don't need protecting?

That's the question the Securities and Exchange Commission tackled under former chairman William Donaldson. And after months of intense, well-publicized debate, the SEC voted 3-2 last year to require hedge funds to register, a rule that will take effect next February.

The new rule contained an interesting caveat, however: Hedge funds with less than $25 million in assets can continue operating unregistered.

Some say the SEC's desire not to place undue burdens on small business is understandable, but when applied to the new hedge fund regulation, the $25 million exemption leaves the smallest funds unregulated – and it is precisely these funds that are more likely to attract individual investors, the group the SEC exists to protect.

"I would argue that SEC has it backwards," said Randy Shain, co-founder of investigative due diligence firm Backtrack Reports. "The person who needs help is the individual investor and they are more apt to invest with someone smaller. It makes a lot more sense to take a look at the smaller funds than it does to look at Caxton," he said, referring to a long-established hedge fund firm with an estimated $12 billion in assets. "(Institutional investors) are not dumb. They get scorched every now and again, but not nearly as often as individuals."

Hedge fund investors, whether individuals or institutions, must meet certain legal requirements to invest. A hedge fund investor must have a net worth of at least $1 million, or an annual income of $200,000 individually or $300,000 with a spouse for three consecutive years.

The $25 million cutoff is not unique to hedge funds, because it was an amendment to the Investment Advisers Act of 1940 that Congress passed during the Clinton administration, according to an SEC spokesman.

When the SEC started investigating hedge funds in 2003, the commission cited the rising number of enforcement actions it has filed against hedge funds as one reason for the increased scrutiny. Over the past five years, the SEC has filed 51 enforcement actions against hedge funds (or, in many cases, people who just claimed to be running hedge funds).

But what the SEC doesn't track is how many funds blew up because of trading losses rather than impropriety. In these cases, managers can simply fold up their tent; they aren't legally obligated to pay back their investors if the investors were made aware of the risk before they made the investment.

Shain estimates that the vast majority of hedge fund blowups are due to incompetence, not fraud, and that many of them are under the radar because the funds under management are so small. He argues that it is individual investors who are much more likely to invest in smaller hedge funds than institutions, and that it's individual investors, not institutions, whom the SEC is mandated to protect.

But supporters of the exemption say that requiring such small funds to register would make starting a new hedge fund onerously expensive, because of the costs associated with registration – including legal fees, staffing costs and other related expenses. These supporters argue that it is important to the growth of the hedge fund industry that new, successful funds are allowed to form without being unduly burdened with high costs from the outset.

The SEC estimates that registration process itself costs about $20,000; Michael Tannenbaum, a partner in the law firm of Tannenbaum Helpern Syracuse & Hirschtritt LLP, said his firm puts the cost higher, with a minimum cost of $35,000 and up. Add to that the fact that firms need to have a compliance officer on staff, according to the new rules, and the cost goes up even higher.

Of course, the debate that will continue long after the rule goes into effect is not whether the SEC is targeting the right funds for registration, but whether registration will help at all in terms of protecting investors. After all, some of those 51 enforcement actions were levied at firms that were already registered with the SEC.

Shain said registration probably wouldn't stop fraud from happening, but creating some barrier might deter inexperienced opportunists – a group he thinks is growing – from launching new funds. It is worth pointing out that the barriers to entry into the hedge fund business in the U.S. are zero – anyone with a Bloomberg machine and a little bit of money can hang out a shingle as a hedge fund manager.

"I don't think registration is a panacea for prevention of frauds or blowups, but on a certain small level, the smaller entity that is pretty much out there for the fast buck won't be able to get it because now you have placed a hurdle to get into the industry itself," he said. "For people who think of this as an easy play where there's no downside – now they have been given downside."

Said Jason Lee, co-chair of the securities enforcement defense group at law firm Shartsis Friese LLP, "At the end of the day, if you are talking about a blatant fraud, registration is not gong to prevent it. What it does do is put (managers) on the map. Investment advisers are subject to regular inspections of their internal controls. So by registering, they do have an obligation to make sure their internal controls are much more solid than they would be if they were not registered. It doesn't prevent outright fraud, but it does add a deterrent."

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For a review of past fund failures, click here.

To see how the new SEC chairman might handle hedge funds, click here.