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Baron Funds

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Baron

Baron Energy and Resources Fund benchmark (S&P North American Natural Resources Index) by 256 basis points for the year and 126 basis points for the fourth quarter. All of the relative underperformance is attributable to poor performance on an absolute and relative basis for virtually the entire portion of the portfolio that was NOT invested in Energy this year and this past quarter. To put a fine point on this, our energy-related investments posted a net contribution for the year of 32.23% compared to gains of 23.34% for our benchmark. However, we generated relative underperformance in Industrials, Consumer Discretionary, Alternative Energy, and especially in Materials, which was the source of the biggest negative variance. Materials stocks in general had a very good year, especially metals & mining (including precious metals and industrial metals), and construction materials. We were underweight Materials all year, which hurt when mining & metals soared in the first half and once again when construction materials stocks got a big boost after the U.S. Presidential election on the prospects of fiscal stimulus and a big infrastructure package. We also suffered from poor stock picks and poor timing in the sub-industries that make up Materials. This was particularly true with the fourth quarter performance of one of our larger holdings in this area–Flotek Industries, Inc., which declined sharply in the fourth quarter following the publication of a short report that called into question the efficacy of the company’s main chemical product. Our research and analysis contradicts what was published in that report, but Flotek’s price decline nevertheless had a meaningful impact on the Fund’s performance in the quarter and for the year overall. On the bright side, we are pleased with the significant success we had investing in the Energy sector in 2016. We came into the year with a substantial cash position of approximately 15%, which was a help early in the year when oil and stock prices were bottoming. The purchases that we made in the first half of the year as we worked that cash down proved to be excellent buys. For example, we established new positions in companies such as Rice Energy Inc., Encana Corp., U.S. Silica Holdings, Inc., and Targa Resources Corp., all of which were among the top 10 contributors to our Fund’s performance for the year and continued to be meaningful holdings at year end. In addition to the performance of these portfolio additions, three of our top five positions throughout the year were our core investments in high quality exploration & production companies, with a focus on the Permian Basin in West Texas. These three companies were also among the most significant contributors to the Fund’s performance in 2016, and we believe they continue to hold significant potential for gains over the next several years. Our investments in the Permian Basin are a reflection of our commitment to long-term investing, as we have held large stakes in Permian-based producers since the inception of this Fund and essentially since I joined Baron Capital seven and a half years ago. Our interest in the Permian Basin revolves around our view that despite being a leading source of U.S. oil production for the past 70 years, the shift toward unconventional drilling and completion technology is still nascent and the resource has a lot of room for growth. The number of economic formations and the recovery rate from each formation combined with above average expected growth rates in production over the next several years, should result in more value creation opportunities. Table II. Top contributors to performance for the quarter ended December 31, 2016 Year Acquired Percent Impact RSP Permian, Inc. 2014 0.96% Encana Corp. 2016 0.72 Halliburton Co. 2012 0.71 Valero Energy Corporation 2015 0.60 Targa Resources Corp. 2016 0.51 RSP Permian, Inc. is an independent exploration and production (E&P) company focused on the Permian Basin in West Texas. Shares rose in the fourth quarter after the company raised its production guidance, delivered strong quarterly results, and acquired Silver Hill Energy Partners in the core of the Delaware sub-basin in the Permian. We believe shares will benefit from improvements in operating results and prudent cost management as the company generates peer-leading production growth and integrates the acquired Silver Hill properties in the Delaware Basin. Encana Corp. is an E&P company with operations in Western Canada and Texas. The stock rose in the fourth quarter after Encana reported production guidance that beat Street expectations, a solid multi-year growth outlook, and lower cash costs. Encana has strong positions in two of the more attractive oil plays in the Permian and Eagle Ford Basins and two of the lowest cost natural gas basins in Western Canada. We believe Encana is one of the most attractively valued E&P companies with strong long-term growth and returns potential. Halliburton Co. is one of the largest diversified oilfield service and equipment companies in the world. Shares increased in the fourth quarter as the company reported strong earnings on lower costs and margins in North America that beat Street expectations. Shares also rallied after OPEC’s decision to cut output. We believe Halliburton has a market-leading position in North American unconventional plays and is the best positioned company to benefit from the ongoing recovery in onshore well completion activity. Shares of Valero Energy Corporation, the largest independent refining & marketing company in the U.S., rose on solid third quarter results driven by lower operating costs and reduced capital budget guidance. Shares also rallied on post-election sentiment that positive regulatory changes will help with rising Renewable Identification Number costs. Valero has produced strong free cash flow and returned cash to shareholders through dividends and share repurchases that we believe will result in a potentially higher share price over the next several years. Targa Resources Corp. has a prime gathering and processing footprint in low cost oil and gas basins (specifically the Permian Basin) and the Gulf Coast. Shares of this midstream energy company rose during the fourth quarter on recovering commodity prices after OPEC signed a deal to cut production. We believe this deal will translate into better visibility, volumes, and operating leverage for Targa, allowing it to stabilize its dividend and improve its coverage ratio, and explore potential avenues for growth through better utilization and footprint expansion. Table III. Top detractors from performance for the quarter ended December 31, 2016 Year Acquired Percent Impact Flotek Industries, Inc. 2013 –1.67% Rice Energy Inc. 2016 –0.49 Newfield Exploration Co. 2015 –0.41 SolarEdge Technologies, Inc. 2016 –0.34 Kraton Corporation 2016 –0.30 Flotek Industries, Inc. supplies chemical additives to the global oil and gas industry. It has a proprietary product (CnF) that helps increase oil and gas shale well productivity. Shares fell in the fourth quarter following a short seller’s assertion that independent consultant studies commissioned by Flotek were based on incomplete data and failed to consider key variables. After incorporating additional data, the consultant confirmed its conclusion 72

December 31, 2016 Baron Energy and Resources Fund that CnF improves well productivity. We expect shares to rebound as Flotek proves demand for CnF remains solid. Rice Energy Inc. is an independent E&P company focused on the Marcellus and Utica shales in Pennsylvania and Ohio. Shares declined in the fourth quarter due to a weakening natural gas outlook and higher exposure to Appalachia in-basin pricing following Rice’s acquisition of Vantage Energy. We believe Rice offers exposure to some of the best acreage and industryleading production growth. We also think that the market underappreciates the value of Rice’s midstream holdings. Newfield Exploration Co. is an independent E&P company focused on shale oil fields in Oklahoma, Utah, and North Dakota. Shares fell in the fourth quarter after the company reported quarterly results that fell short of analyst expectations despite raised production guidance and increased activity in its highest return assets in Oklahoma. We like shares at these prices and believe there is more upside to resource potential and opportunities for Newfield to sell non-core assets to accelerate development of its higher return assets. SolarEdge Technologies, Inc. is a leading provider of DC optimizers and inverters for residential and commercial solar systems. The share price fell in the fourth quarter on investor concerns around sluggish residential market growth as a result of changing purchase behavior and slowing growth of the largest installers. New competitors are looking to penetrate the U.S. market in 2017, suggesting amplified pricing pressure above market expectations and potentially lost market share for SolarEdge. We exited our position. Shares of specialty chemical company Kraton Corporation decreased in the fourth quarter as management reduced fiscal year guidance again. We believe the reduction was due to exogenous, temporary factors, leaving our long-term thesis intact. We think the company is on track to execute its plan to grow earnings through cost savings, acquisition synergies, and organic growth, while generating significant free cash to delever the balance sheet, accruing value to equity holders. Portfolio Structure We ended the year with 0.6% cash, which continues to reflect our desire to run the Fund at a fully invested level that reflects our optimism about the forward outlook for the industries and companies in which we invest. The Fund remains concentrated, with the top 10 holdings representing 46.5% of the Fund at year end, down slightly from the end of the third quarter. Our level of concentration is consistent with our strategy of having a high active share and being a long-term investor in the companies in which we choose to invest. Our active share at year-end 2016 was 82.05%. Our three-year average turnover ratio was still 41.6%, even though we engaged in a higher than normal amount of turnover in the Fund in the past 12 months, as we harvested losses at year-end 2015 and refocused the Fund into a more concentrated, higher conviction portfolio. We believe that our commitment to detailed company research, high active share, and low turnover could potentially lead to superior results over the long term for our investors. At the end of the year, the portfolio breakdown in the key sub-industries was as follows: Oil & Gas Exploration & Production: The E&P sub-industry represented 47.5% of the Fund at the end of the quarter, and continued to be focused on North American-based producers that operate primarily in developing unconventional oil & gas reservoirs. Companies that primarily operate in the Permian Basin in Texas and New Mexico are our largest focus for E&P investments, followed by companies that are focused on the Anadarko Basin in Oklahoma, the Appalachian Basin in Pennsylvania/Ohio, and the Western Canadian Sedimentary Basin. These plays are characterized by multiple payzones, industry-leading returns, and expanding resource potential, and stocks such as RSP Permian, Inc., Parsley Energy, Inc., Concho Resources, Inc., Encana Corp., and Newfield Exploration Co. are key investments in these plays and were key contributors to our performance this year and this quarter. We continue to be bullish on the long-term growth potential of these four plays and the companies that are the leading developers in each. Oil & Gas Storage & Transportation: This sub-industry, which is a mix of MLPs, publicly traded general partnerships, and C-Corp structured companies that own and operate critical oil & gas processing, and storage and transportation infrastructure, is the second largest sub-industry for the Fund and it represented 18.8% of the Fund’s assets at the end of the quarter. We continued to see improving conditions in this sector, particularly for storage and transmission related companies. Many companies in this sub-industry have undergone financial and strategic restructurings in the last 12 months, resulting in stronger balance sheets and streamlined corporate structures. In addition to these actions, a more positive outlook for commodity prices has also eased investor concerns about future dividend/distribution growth, enhancing the relative valuation comparison for these stocks versus other yield-oriented investments like Utilities, REITs, and Consumer Staples. As a result, investment flows into dedicated MLP/midstream funds have picked up over the past six months and the increase in investment flows has also coincided with declining capital needs as a result of slower organic growth. The reduction in capital needs along with a series of M&A transactions have reduced the supply of equity, which we view as a positive for our investments in this area. Oil & Gas Equipment & Services & Drilling: At 16.5%, our exposure to these related sub-industries was up again in the fourth quarter due primarily to share price appreciation and some modest purchases. The equipment and service companies that we added to the portfolio in the third quarter and were referenced in last quarter’s letter were all solid contributors to the Fund’s performance in the past quarter. As expected, the outlook for a recovery in oilfield drilling and completion activity in North America is brightening as a result of the increase in oil prices, and even at this early stage of recovery we are beginning to see the green shoots of pricing improvement that along with activity growth should lead to accelerating earnings gains over the course of the next several years. We continue to harbor concerns about valuation and normalized earnings power in this subindustry, but we are more comfortable that the restructuring of the past two years could result in a more positive earnings recovery than is currently embedded in consensus estimates and in consensus valuations. Renewable Energy: Renewable or alternative energy is not a specific GICS sub-industry, but we think this is really the appropriate classification for our investments in the Utilities and Information Technology sectors, since our investments in these two areas are primarily companies involved in the construction and operation of solar and wind electricity generation assets and battery storage systems. Investments in this area accounted for 7.8% of the Fund at the end of the quarter, and performance was mixed for the quarter and for the year. Our ongoing investment in Tesla Motors, Inc. and our new purchase of Infraestructura Energetica Nova S.A.B. de C.V. were positive contributors during the fourth quarter, while our holdings in TerraForm Power, Inc. and TerraForm Global, Inc. were modest detractors and continue to be dominated by the ongoing Chapter 11 process for their parent company SunEdison. Third-party investors have expressed interest in buying part or all of both companies in recent months and a path forward 73

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