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Baron Funds

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Baron

Baron Growth Fund Dear Baron Growth Fund Shareholder: Performance The long-term absolute and relative performance of Baron Growth Fund has been exceptional… Since its inception on December 31, 1994, Baron Growth Fund’s (the “Fund”) 12.56% (Institutional Shares) annualized performance for 22 years has exceeded that of its benchmark Russell 2000 Growth Index by an average of 5.01% per year. This means that a $10,000 investment in Baron Growth Fund at its inception 22 years ago would now be worth $135,000! If an investor had instead purchased $10,000 in a passive index fund that mirrored the Russell 2000 Growth index, it would now be worth $50,000! Please see Table I and Table II and the Baron Growth Fund performance chart following the “Letter from Linda.” Table I. Performance Annualized for periods ended December 31, 2016 Baron Growth Fund Retail Shares 1,2 Baron Growth Fund Institutional Shares 1,2,3 Russell 2000 Growth S&P 500 Index 1 Index 1 Three Months 4 (0.14)% (0.08)% 3.57% 3.82% One Year 6.04% 6.31% 11.32% 11.96% Three Years 1.94% 2.20% 5.05% 8.87% Five Years 11.27% 11.56% 13.74% 14.66% Ten Years 6.43% 6.63% 7.76% 6.95% Fifteen Years 8.35% 8.49% 7.48% 6.70% Since Inception (December 31, 1994) 12.46% 12.56% 7.55% 9.55% Baron Growth Fund’s beta has averaged 0.68 since inception. This means the Fund has been 68% as volatile as its benchmark. Please see Table III. As a result of Baron Growth Fund’s strong absolute and relative returns and lower risk, the Fund has achieved 6.91% annual “alpha,” a measure of riskadjusted performance, since inception. …despite modest gains we achieved during the past three years, and, most notably, during the past six months, which negatively impacted Baron Growth Fund’s relative performance over the past one-, three-, five- and ten-year periods. We believe Baron Growth Fund’s recent performance is analogous to several instances when, after brief periods of underperformance, the Fund again substantially outperformed. One instance in particular stands out. During RONALD BARON CEO AND PORTFOLIO MANAGER Retail Shares: BGRFX Institutional Shares: BGRIX R6 Shares: BGRUX the 18-month period from October 1998 through March 2000, at the height of the internet bubble, Baron Growth Fund, which owned no internet stocks, increased in value 67.61% annualized, while its benchmark increased 108.38% annualized! For the next nine years through December 2008, Baron Growth Fund outperformed its index by approximately 700 basis points per year. Of course, past performance cannot reliably predict future results, but we expect this Fund’s investments to soon again outperform. We attribute the Fund’s recent modest performance principally to three factors. 1. During the past three years, 32.6% of Baron Growth Fund’s assets as of 12/31/2016 were invested in 22 businesses whose stock prices significantly underperformed the growth of their businesses. SS&C Technologies Holdings, Inc.’s recurring financial services revenues increased 106% since 2013 while its share price increased 31.6%. Soccer club Manchester United plc’s licensing, sponsorship, and media revenues grew significantly during the past three years, creating 34% revenue gains and 58% EBITDA growth. Its share price fell 6.7%. Investment advisor Financial Engines, Inc.’s assets under management increased roughly 60%. Its share price has fallen 45.9%! The book value for airplane lessor Air Lease Corp. has increased 61% since 2013 while its stock price has increased only 12.2%. Bio-Techne Corporation’s sales of proteins, antibodies, and other products to scientists at academic labs, biopharma companies and other Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Retail shares and Institutional shares as of September 30, 2016 was 1.30% and 1.05%, respectively. The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. The Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted. For performance information current to the most recent month end, visit www.BaronFunds.com or call 1-800-99BARON. 1 The indexes are unmanaged. The Russell 2000 ® Growth Index measures the performance of small-sized U.S. companies that are classified as growth and the S&P 500 Index of 500 widely held large cap U.S. companies. The indexes and the Fund are with dividends, which positively impact the performance results. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell is a trademark of Russell Investment Group. 2 The performance data in the table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares. 3 Performance for the Institutional Shares prior to May 29, 2009 is based on the performance of the Retail Shares, which have a distribution fee. The Institutional Shares do not have a distribution fee. If the annual returns for the Institutional Shares prior to May 29, 2009 did not reflect this fee, the returns would be higher. 4 Not annualized. 22

December 31, 2016 Baron Growth Fund customers have increased 60% in the past three years while its share price has increased 13.0%. Human resources software vendor Benefitfocus, Inc.’s revenues increased 125% during the past three years; its share price fell 48.6%; and its business is continuing to grow strongly…as is the case for all the companies mentioned above…and the other companies in which we have invested whose share prices were disconnected from their business growth in the past three years. We do not expect this disconnect to continue to be the case. 2. Virtually all the businesses in which Baron Growth Fund has invested are incurring significant expenses that penalize their current earnings, and possibly their current stock prices, to become much larger businesses. Whether by hiring more sales staff, developing new products, starting up new manufacturing plants, providing additional client services, investing in new databases, integrating acquisitions or producing new products at lower gross margins than will be achieved at scale. While most businesses make such expenditures, the magnitude of these investments relative to the size of the businesses in which we have invested is unusual. Further, 62.2% of Baron Growth Fund’s investments at 12/31/2016 have made strategic acquisitions in the past two years. We expect these transactions to be additive to growth, earnings, and share price over the next few years. Specialty insurance and reinsurance company Arch Capital Group Ltd. acquired mortgage insurance business United Guaranty from AIG. We regard that business as one of AIG’s “crown jewels,” believe it is a wonderful fit with Arch Capital’s existing mortgage guarantee business, and believe it was purchased at an unusually attractive price. Vail Resorts, Inc. purchased Canadian ski resort Whistler Blackcomb in what we regard as a highly synergistic and strategic transaction that will enhance results at Whistler and across the broader Vail portfolio. The acquisition will add to Vail’s customer data base, which is already the largest in the industry, and increase Vail’s annual ski pass sales. Douglas Emmett, Inc., the dominant owner of office buildings in west Los Angeles, partnered with Qatar Investment Authority to purchase 1.7 million square feet of underoccupied, underperforming office assets in that submarket. This market is particularly attractive due to secular demand growth and significant limits on further construction. 3. The surprising results of the November 8, 2016 U.S. presidential election immediately impacted domestic stock markets. Baron Growth Fund did not benefit materially. Following the election, top-down investors purchased stocks in sectors they believed would benefit from Trump programs. Cyclicals such as Financials, Energy, Materials, and Industrials did well. Less economically sensitive Consumer Staples and Health Care stocks did not perform as well. Real Estate and fast growing Information Technology (IT) investments also did not fare as well. Especially noteworthy, in our opinion, was the 28.8% increase in the valuations of small regional banks that would benefit from less regulation and wider net interest margins when interest rates increase. Baron Growth Fund has no investments in small regional banks, because we believe that their balance sheets are opaque and competitive advantages are unclear. Baron Growth Fund is a bottom-up, fundamental, long-term investor in what we believe are fast growing, competitively advantaged, wellmanaged businesses. We believe that over the long term the stock market and economy are closely linked and both will continue to double in value about every 12 years…as has been the case since 1960. We are not trying to beat our benchmark in the short term by making “macro” judgments. We invest only in growth businesses that we think can double in value about every five or six years. Although real estate businesses’ rents and replacement values should increase if inflation increases, our real estate stocks fell 1.6% during the quarter. This is because real estate investment trusts are viewed as “yield” stocks and higher interest rates mean that yield in the short term is worth less. Although our real estate investments did not contribute to the Fund’s returns in the fourth quarter, they increased in value 18.1% in 2016. The Fund has 8.4% of its portfolio invested in unique real estate businesses like Alexandria Real Estate Equities, Inc., with its competitively advantaged medical research campuses; Douglas Emmett, whose fully leased core properties in Los Angeles have been made even more valuable by recently simplified zoning regulations; Gaming and Leisure Properties, Inc., with substantial growth opportunities for its competitively advantaged, licensed, regional casinos; and Alexanders, Inc., with its irreplaceable New York City real estate assets. Services provided by competitively advantaged, growing IT businesses in which Baron Growth Fund has been a shareholder for years boost productivity of their clients. These IT companies are benefiting from powerful secular trends, and are penalizing their earnings in the short term to enhance long-term growth. Baron Growth Fund’s IT investments fell in price in the fourth quarter by 2.3%, on average. Baron Growth Fund has 21.2% of its portfolio invested in successful IT growth companies like CoStar Group, Inc., Guidewire Software, Inc., SS&C Technologies, and Benefitfocus. The share prices of all of these companies experienced double-digit price declines in the period. This is despite what we call their KPIs, or “key performance indicators,” continuing to increase significantly. KPIs for these businesses include measures of recurring subscription revenues, number of salespeople, number of users, and average revenue per user. Against this backdrop, Baron Growth Fund declined in value 0.08% (Institutional Shares) during the December quarter, trailing the Russell 2000 Growth Index, the small-cap benchmark against which we compare the Fund. That index rose by 3.57% during the quarter. For the full year, the Fund returned 6.31% while the index increased 11.32%. Baron Growth Fund has significantly outperformed its peers over the long term. Baron Growth Fund purchases only small-cap companies. However, since the Fund holds its growth company investments on average for more than 12.5 years, the Fund has a significant percentage of its assets invested in securities that have appreciated beyond their market capitalizations at the time of the Fund’s initial investment. Please see Table IX. 23

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