1 year ago

Baron Funds



Baron Real Estate Fund Dear Baron Real Estate Fund Shareholder: Performance The Baron Real Estate Fund (the “Fund”) completed its seventh year of operation on December 31, 2016. We are pleased to report that, according to Morningstar, the Baron Real Estate Fund is ranked in the top 5% of all U.S. real estate funds for its sevenyear performance, and also ranked in the top 1% of all U.S. real estate funds for its most recent five-year period ended December 31, 2016.* During the seven years since its inception, the Fund generated an annualized return of 14.37% (Institutional Shares), outperforming its primary benchmark, the MSCI USA IMI Extended Real Estate Index (13.16% annualized return), the S&P 500 Index (12.83% annualized return), and the MSCI U.S. REIT Index (12.28% annualized return). Cumulatively, the Fund’s seven-year return has totaled 156.02% (Institutional Shares), compared to 137.58% for the MSCI USA IMI Extended Real Estate Index and 132.85% for the S&P 500 Index. Despite the Fund’s solid seven- and five-year performances, certain factors have tempered the Fund’s results during the past few years. These include: (i) persistently declining interest rates to historically low levels that aided dividend-focused REIT funds; (ii) the Fund’s relatively moderate allocation to REITs; (iii) a few investment missteps; and (iv) the particularly strong share price performance of Home Depot, Inc. and Lowe’s Companies, Inc., which together accounted for a combined 13% outsized weighting of the MSCI USA IMI Extended Real Estate Index, versus the Fund’s more moderate 5% weighting in these two companies. The Fund’s performance last year was also impacted, in part, by certain unfortunate geo-political and tragic events that can be attributed, in part, to ordinary “bad luck.” First, a series of international terrorist acts and fears over the Zika mosquito virus negatively impacted the Fund’s holdings in cruise line operators. Also, the surprising referendum vote in the U.K. to withdraw from the European Union (“Brexit”) triggered widespread uncertainty regarding the prospects for commercial real estate services companies in Europe. Notably, the Fund is back in stride. In the last six months of 2016, the Fund has outperformed the MSCI U.S. REIT Index by 729 basis points, increasing 2.30% (Institutional Shares) while the MSCI U.S. REIT Index fell 4.99%. During this same six-month period, the Fund has outperformed its primary benchmark, the MSCI USA IMI Extended Real Estate Index, by 200 basis points, increasing by 2.30% versus 0.30% for the index. We are optimistic about the Fund’s ongoing prospects. JEFFREY KOLITCH PORTFOLIO MANAGER Table I. Performance Annualized for periods ended December 31, 2016 Baron Real Estate Fund Retail Shares 1,2 Baron Real Estate Fund Institutional Shares 1,2 Retail Shares: BREFX Institutional Shares: BREIX R6 Shares: BREUX MSCI USA IMI Extended Real Estate S&P 500 Index 1 Index 1 Three Months 3 0.02 % 0.09 % 0.20% 3.82% One Year (2.01)% (1.75)% 8.24% 11.96% Three Years 2.90 % 3.17 % 9.30% 8.87% Five Years 14.58 % 14.89 % 14.26% 14.66% Since Inception (December 31, 2009) (Annualized) 14.09 % 14.37 % 13.16% 12.83% Since Inception (December 31, 2009) (Cumulative) 3 151.63 % 156.02 % 137.58% 132.85% Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Retail Shares and Institutional Shares as of December 31, 2015 was 1.31% and 1.06%, 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 Adviser has reimbursed certain Fund expenses (by contract as long as BAMCO, Inc. is the adviser to the Fund) and 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 or call 1-800-99BARON. 1 The indexes are unmanaged. The MSCI USA IMI Extended Real Estate Index is a custom index calculated by MSCI for, and as requested by, BAMCO, Inc. The index includes real estate and real estate-related GICS classification securities. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, reviewed or produced by MSCI. The S&P 500 Index measures the performance of 500 widely held large cap U.S. companies. The indexes and the Fund include reinvestment of interest, capital gains and dividends, which positively impact the performance results. 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 Not annualized. * The Morningstar US Fund Real Estate Category Average is not weighted and represents the straight average of annualized returns of each of the funds in the Real Estate category. Morningstar rankings are based on total returns and do not include sales charges. Total returns do account for management, administrative, and 12b-1 fees and other costs automatically deducted from fund assets. As of December 31, 2016, the category consisted of 267, 208, and 165 funds for the 1- and 5-year periods and since inception. Morningstar ranked Baron Real Estate Fund Institutional Share Class in the 99 th ,1 st , and 5 th percentiles, respectively, in the category. 58

December 31, 2016 Baron Real Estate Fund Reflections on the Last Seven Years: General Observations We thought this would be an appropriate time to reflect on the Fund’s history. The Baron Real Estate Fund was launched seven years ago, on the heels of the “Great Recession,” one of the worst economic downturns in U.S. history. The past seven years have been an uncommon environment for business, including real estate. For much of this timeframe, the persisting effects from the Great Recession – a sluggish economy, a stubborn and lackluster housing market, little or no wage growth, a dearth of capital investment by the business community, and other factors – combined to restrain a comprehensive U.S. economic recovery. A key consequence has been that interest rates today are 36% lower than they were at the beginning of the recovery seven years ago! At the launch of the Fund on December 31, 2009, the 10-year U.S. Treasury yield was 3.83%, followed by a major yield decline to an all-time low of just 1.36% by July 2016, before finally settling at the year-ending historically low yield of only 2.44%. THE FUND: During this seven-year period of predominantly sluggish growth and declining interest rates, the performance of the Baron Real Estate Fund has been quite strong in certain years, and less satisfactory in others. Yet, the Fund’s overall seven-year performance has been quite strong, as we mentioned at the start of this letter. As interest rates and bond yields stagnated around historically low levels, the search for income producing securities stoked investment interest in dividend-focused REIT funds, especially from 2014 through 2016. The Baron Real Estate Fund, with its investments in several categories of real estate-related companies (in addition to REITs), was able to successfully navigate the highly unusual interest rate environment and challenging business cycle of the last seven years. Looking forward, if economic activity and interest rate levels return to “historical averages,” we believe the Baron Real Estate Fund will be well positioned to continue to perform well. The Next Seven Years: Top-of-Mind Considerations As we peer into 2017 and contemplate various factors that are likely to influence the stock and bond markets, and more particularly real estaterelated stocks, the list is lengthy. We, at Baron, are attentive and prepared. Key considerations include: • The Trump Presidency and its impact on U.S. and global economies and the equity and fixed income markets • The direction and pace of change for macroeconomic considerations such as GDP growth, interest rates, inflation, the U.S. dollar, and oil prices • The future actions of central banks, in particular, the Federal Reserve, and its pivot from several years of accommodation to a more restrictive, higher interest rate posture • Geopolitical considerations and terrorism • Company-specific initiatives and actions No one has a crystal ball 2016 was a year full of unpredictable events. Some prime examples were: The worst-ever yearly start for the S&P 500 Index, the unanticipated Brexit vote, and Donald Trump’s stunning nomination and election victory following a highly unconventional and extremely divisive U.S. Presidential nomination and election campaign. We agree with Howard Marks, Chairman of Oaktree Capital, who recently noted that if there are two key takeaways from 2016, they are that: • No one knows with clarity the events that are going to transpire • No one knows what the market’s reaction to those events will be Top-of-mind questions Though we agree with Howard Marks that we, too, do not have a crystal ball regarding the long list of economic, market, and real estate opportunities that may unfold in the years ahead, the following are three top-of-mind topics: • What are our thoughts regarding the possible ramifications from the Trump Presidency? • What is the outlook for real estate? • What is the outlook for the Baron Real Estate Fund? We urge you to read our “Outlook” section in the latter part of this letter where we address the above questions. Table II. Top contributors to performance for the quarter ended December 31, 2016 Quarter End Market Cap (billions) Percent Impact MGM Resorts International $16.5 0.74% Hilton Worldwide Holdings, Inc. 26.9 0.67 Martin Marietta Materials, Inc. 14.1 0.57 CBRE Group, Inc. 10.6 0.51 Vulcan Materials Company 16.6 0.28 The shares of MGM Resorts International, a leading hotel and casino company, continued to perform well in the fourth quarter of 2016 largely due to strong financial results and an expectation for further favorable business prospects. We remain optimistic about the prospects for the company because we believe that MGM offers an attractive combination of high quality real estate assets; a leading presence in Las Vegas, one of the strongest real estate markets in the U.S.; a strong growth outlook; and ownership of attractively valued real estate at only 8.5 times 2017 estimated cash flow (a level that we believe is a significant discount to its private market value). The shares of leading hotel operator, Hilton Worldwide Holdings, Inc., performed strongly in the fourth quarter due in part to its discounted valuation and expectations that economic prospects may improve during the Trump administration. We recently attended Hilton’s Investor Day. The company showcased the management teams that will lead the three newly formed companies following Hilton’s long-awaited strategic plan to separate its business into three distinct companies to maximize value. On December 31, 2016, Hilton completed its separation into three distinct businesses – Hilton Worldwide Holdings, Inc. (a leading hotel fee business 59

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