And the Portland, Ore.-based firm also had money with many remaining short-focused firms, including Fichthorn's Dialectic, Matt Kliber's Gracian Capital and Dave Davidson's SC Management, according to the people.
"Common Sense was the straw that broke the back of the marginal short-selling fund. They were the most thoughtful guys left in the fund of funds space in terms of allocating to smaller short-focused managers," said one of the fund managers who Common Sense redeemed from.
Davidson had Common Sense as a client since 2004 and, like others, lamented the fallout from the personal transgressions of one individual. "They're great investors with a great team," he said.
Common Sense did not respond to a request for comment.
(See also: Investors flee fund after founder's prostitution bust)
Shorting has also been a brutal game of late. Two of the most high-profile bets against companies—Pershing Square Capital Management's short of Herbalife and Greenlight Capital's move against Green Mountain Coffee Roasters, appear to have lost both firms significant money on paper so far.
Some of the most heavily shorted stocks have even outperformed equity indexes this year. They include Tesla Motors, Chipotle Mexican Grill, Netflix and Best Buy.
While shorts have been costly, many hedge fund managers have performed well by putting more money in their longs than their shorts. For example, David Einhorn's Greenlight is up 11.8 percent for the year through September and Bill Ackman's Pershing Square is up 8.1 percent through October despite its short losses.
Performance for the largest short-biased hedge fund firm, Jim Chanos' $6 billion Kynikos Associates, was unavailable. The firm didn't respond to requests for comment.
Another firm that has done well is Kerrisdale Capital Management. Sahm Adrangi started the firm in July 2009 with less than $1 million and made his name shorting Chinese companies like China Education Alliance and Advanced Battery Technologies.
The firm now manages approximately $300 million and is up about 20 percent this year through mid-November, according to an investor. The fund has been an average of 80 percent net long this year, according to Adrangi.
"I think shorting is a difficult way to make money over the long run. It can be done but it's a tougher way to generate wealth over the long term in most markets, especially over the last four years," Adrangi said.
Despite the struggles, short-focused managers couldn't be more excited about the opportunity.
"The quantity and quality of short signals, especially in large caps, have not been this robust since late '06 or early '07—the period that preceded the last recession," said Kliber of Gracian, which focuses on large companies to avoid the high cost of borrowing associated with many shorts. "The evidence of revenue strain and earnings risk among large companies is not fully reflected in consensus estimates."
Another is Davidson of $50 million SC Management.
"Since the 2009 lows, we're in (Fed Chairman Ben) Bernanke's grand experiment of QE, which hasn't created the job or wage growth desired. Financial assets have benefited, but now it's time for investor caution," said Davidson.
His fund is down 25 percent this year but gained 55 percent net of fees from 2000 to 2012, including a return of 59 percent in 2008.
Fichthorn of Dialectic echoed those themes. "You don't see these price to sales multiples on unprofitable businesses ever in history," he said. "It's a bubble—regardless of what the (Fed Open Market Committee) says. After all, they missed and/or caused the last three bubbles."
"Everything would give you the indication that shorts are being forced out of the market just as we're going through the second Internet bubble," Fichthorn added. "Social media, three-dimensional printers, service software businesses, Chinese Internet companies, you name it—the valuations are completely unsustainable and disconnected with reality, which presents an amazing opportunity for the patient short seller."
At least one manager is launching a new short-focused hedge fund. Bill Fleckenstein shut a short-biased fund in 2009 because he believed the shorting opportunity was over, but now plans to launch a fund in early 2014 with Wesley Golby, formerly a portfolio manager at S Squared Technology.
"Once the markets begin to react to consequences of all this money printing, then it will be like shooting fish in a barrel from the short side," Fleckenstein said.
Fleckenstein said companies in sectors like three-dimensional printers and social media are drastically overvalued. He believes that a good indicator for the beginning of a market correction will be when 10-year U.S.Treasury note yields rise to 3 percent from their current level of about 2.69 percent.
It's not clear what investors think.
Some say alternative investors are still bullish.
"The current mood among professional investors remains decidedly risk-on," said Daniel Celeghin, a management consultant on alternative investing with Casey Quirk. "Dedicated equity short-selling strategies have not been too popular, as most investors prefer to pay a premium fee for managers who make the timing call for them, and not for a fairly static market exposure."
That irks short sellers. "It's shocking to me that long-term investors aren't taking a long-term view of their books," said Fichthorn. "No one is positioned for a down market. You can see it in exposures."
One indicator of that risk-on mindset is the recent launch of various long-only private funds from Tiger Global and Coatue Management, for example.
(Read more: Tiger Global launches long-only fund)
Others think investors are finally warming to short sellers. For example, data tracker eVestment has slightly more money flowing to short-biased hedge funds in recent months, a reversal from outflows for the rest of the year.
"Anyone with a brain I think can tell that there's a tremendous opportunity setting up on the short side," Fleckenstein said. "Exactly when that's going to happen and will you be able to capture it well are different issues. But there's just no doubt about it. If you think that all this is all going to end well and there isn't going to be a spectacular collapse at some point in the coming year, plus or minus, then you really are naïve."
Dialectic—which manages almost $600 million overall with about half in a short strategy—was up 37.9 percent in 2008 and 21.36 percent in 2011 but fell 26.29 percent in 2012 and is down 21.13 percent this year through October, according to a person familiar with the fund. Dialectic declined to comment on its returns.
As the equity markets continue to hit record levels, time will tell if the shorts are right and if investors believe them.
"Short selling as a strategy is like an umbrella," Gracian's Kliber said. "People don't think they need one until it starts to rain and they get wet."
—By CNBC's Lawrence Delevingne. Follow him on Twitter @ldelevingne.