Baron SMID Cap ETF | Q3 2026

The Baron SMID Cap ETF (the Fund) had a solid relative performance rebound in the third quarter. The Fund declined 2.87% (NAV) while the Russell 2500 Growth Index (the Benchmark) fell 10.35%, resulting in outperformance of 7.48%. For the year-to-date period ended September 30, 2026, the Fund was up 0.44%, trailing the Benchmark’s gain of 7.28% by 6.84%. Of that nine-month underperformance, just under 4% was attributable to style-related headwinds from Momentum (-2.66%) and Beta (-1.28%). In other words, our relative performance was hurt mainly because we do not invest based on short-term market factors or styles. We believe the momentum phase of the market, in which investors bought AI-related names almost exclusively and at essentially any price, is moderating, which should favor our style of long-term fundamental investing. We began to see this in the third quarter, when the Momentum and Beta factors reversed and aided the Fund’s relative performance by about 3% (Momentum +2.58% and Beta +0.44%).

As we noted in our letter last quarter, the momentum that had sustained the "AI winners" trade through the first half of the year was bound to slow. The likely catalysts were a combination of higher interest rates, concerns about delays in the construction of AI data centers (which affect the entire AI infrastructure supply chain), and high valuations. Together, these dampened what had been an unrelenting momentum-driven market. The semiconductors sub-industry in the Benchmark, one of the hottest in the first half of 2026, was down 17.9% in the quarter, and semiconductor materials & equipment fell 23.4%. We are underweight these sub-industries. A number of other AI-driven sub-industries where we have limited to no exposure also fell meaningfully, including electronic components (-19.7%), electronic manufacturing services (-26.8%), electronic equipment & instruments (-20.2%), communications equipment (-21.2%), and technology hardware storage & peripherals (-22.7%).

The market also recognized that software companies vary widely in quality, and that AI-generated code cannot, by itself, displace every existing software company. In our first-quarter 2026 letter, we wrote that software is:
 

"an industry where we believe our particular investments are fundamentally misclassified as AI losers... We believe that there are four main categories of software that will co-exist with large language models (LLMs). They include: (1) companies that generate and use deterministic data (only available to the private enterprises, and NOT available to LLMs); (2) highly integrated vertical software providers with extreme domain expertise; (3) companies that combine 'atoms and electrons' where the solution needs physical products combined with software; and (4) companies whose software requires regulatory approval such as health care software needing FDA approval."

Our overweight to the software cohort paid off in the third quarter. The Fund’s software holdings rose nearly 28%, far ahead of the 3.8% return of software in the Benchmark, and contributed 3.85% to the Fund’s return, reflecting the quality of our stock selection. Software stocks that meaningfully contributed in the quarter included Rubrik, Inc., a data backup and resilience company (deterministic data), which added 1.35% to the Fund's third-quarter return; Netskope, Inc., a zero trust network and application access company (atoms and electrons), which added 0.93%; Dynatrace, Inc., a network software and infrastructure observability company (highly integrated/deterministic data), added 0.80%; and Samsara Inc., an atoms and electrons company that uses software and sensors on vehicles to monitor driver safety and route logistics, which added 0.46%.

Health Care was also a significant contributor. The Fund’s Health Care holdings rose approximately 16% in the quarter, adding 2.68% to the Fund's return, compared with a negative 0.67% contribution for the Benchmark. Life sciences tools & services finally got some wind in its sails as fundamentals appear to be on track for meaningful improvement. Standouts in this sub-industry included Tempus AI, Inc., a cancer diagnostics and AI driven data analytics company, which added 1.31%; Repligen Corporation, a provider of equipment used to manufacture biologic drugs, which added 0.75%; Illumina, Inc., the leading provider of gene sequencing equipment, which contributed 0.67%; and Stevanato Group S.p.A., which provides specialized glass and autoinjectors used with the latest biologic drugs, including GLP-1 weight loss formulations, added 0.24%.

Consumer Discretionary hurt returns by 1.18%, as higher fuel prices and interest rates are weighing on consumer confidence and spending, especially among middle- to lower-income consumers.

Industrials was our worst performing sector, detracting 6.17% from performance. The weakness was driven mostly by aerospace & defense (-3.30%) and, to a lesser extent, electrical components & equipment (-0.74%, largely due to the AI trade reversal), building products (-0.71%, as elevated mortgage rates dampened housing activity and new home construction), and environmental & facilities services (-0.57%, partly consumer related).

We are constructive on the aerospace & defense sub-industry for several reasons.

Defense. First, we believe that while the market is rightly concerned about defense budgets in general, it is overly discounting the effect of a Democrat-led sweep of Congress. We think budgets will rise regardless of the composition of Congress. Moreover, our investments are geared toward areas of the budget that are set to grow rapidly, including missile defense, space, unmanned vehicles, and hypersonics. Our defense companies trade at inexpensive valuations, and we think defense stocks could rebound sharply after the November elections.

Aerospace. Aerospace is being hurt by high fuel prices and instability related to the conflicts in the Middle East, specifically activity in the Strait of Hormuz and the Bab al-Mandab Strait in the Red Sea area. Within this sub-industry, the key long-term factors to follow are new aircraft build demand (the original equipment manufacturer, or OEM, revenue side of the sub-industry), and revenue passenger kilometers (RPKs) flown and aircraft retirements (the aftermarket revenue side). On the OEM side, the International Air Transport Association estimates a backlog of over 18,000 aircraft on order books, likely six to ten years' worth of production. While delivered revenue could vary from year to year, the OEM side looks very healthy. On the aftermarket side, negative RPK growth is exceedingly rare. In the 25 years we have followed the sub-industry, it has happened only three times: after the September 11 terrorist attacks in 2001, after the 2008 global financial crisis, and during the COVID lockdowns of 2020. Rebounds tend to occur very quickly, and over the long run the aircraft aftermarket is a very profitable growth business. With a massive backlog in new aircraft (underproduction), existing aircraft will be flown longer, leading to more maintenance and aftermarket parts needs.

Shares of Rubrik, Inc., a cybersecurity and data resilience platform, contributed to performance as a rising tide in cybersecurity spending lifted the name. A string of high-profile agentic AI security incidents this year has pushed cyber resilience and data recovery to the top of CIO and CISO priority lists, and Rubrik, with a platform that unifies backup, identity, and recovery to enable rapid recovery from breaches, is a direct beneficiary of that budget shift. This theme was validated in the company's fiscal second quarter results, where net new subscription annual recurring revenue (ARR) reaccelerated to 35% year-over-year growth, roughly 27% above consensus, while subscription ARR contribution margin expanded to 14% from 9.4% a year ago. Management raised full-year guidance across every metric by more than the size of the quarterly beat. We maintain high conviction in Rubrik's long-term prospects as enterprises continue to prioritize resilience alongside prevention.

Tempus AI, Inc. is an intelligent diagnostics and health care data company with two synergistic business units: Genomics Testing and Data Solutions. The data generated from Tempus’ diagnostic tests enhances its data business, as Tempus combines its genomics data with clinical patient data from its oncology partners, to generate an enormous proprietary multimodal dataset. Shares were up meaningfully in the quarter on earnings and full-year guidance that beat consensus. Management was very bullish about the data business, noting a very strong biopharmaceutical pipeline. It also acquired Personalis, Inc., a company that specializes in MRD (minimal residual disease) testing to track cancer recurrence. MRD testing is a large market and fits nicely into the Tempus testing and data portfolio in our estimation.

Shares of Netskope, Inc., which secures enterprise traffic to cloud and AI applications, contributed to performance in the quarter. Demand across network security inflected as CISOs and CIOs prioritized modernizing their networking and security stacks for agentic AI traffic, which multiplies machine-to-machine transactions, widens the attack surface, and lowers the cost of attack. We believe Netskope is well positioned for that shift, operating a private cloud network across more than 120 data centers that inspects traffic in real time with a latency advantage that matters more as agents proliferate. The backdrop showed up in results: ARR grew 27% year-over-year, revenue growth accelerated to 29% year-over-year, net new ARR returned to growth, and operating margin improved 11 percentage points year-over-year, prompting a full-year guidance raise. We retain conviction given this architectural differentiation and early traction in AI security.

Axon Enterprise, Inc. is a public safety technology company best known for its TASER conducted energy devices, body-worn cameras, and cloud-based software for evidence management and law enforcement operations. Shares declined despite a good second quarter, as investors questioned how heavily the company’s free cash flow guidance is weighted toward the second half of the year. We do not expect this to be an issue heading into third quarter earnings. A few weeks later, the company issued convertible debt, which raised dilution concerns. Overall, the fundamentals continue to look very strong, and we believe the shares can re-rate as the company executes.

Forgent Power Solutions, Inc. is a leading manufacturer of electrical distribution equipment for data centers, the power grid, and industrial applications. The company specializes in low- and medium-voltage equipment and focuses on custom, “engineered-to-order” products, which make up more than 90% of revenue. Larger competitors generally concentrate on higher-voltage and standard products. The stock declined during the quarter as sentiment turned against the broader AI infrastructure group, even though Forgent reported results and guidance well ahead of market expectations. Bookings reached $1.5 billion in the quarter, far above its current revenue run-rate.

Forgent is taking share by offering customized products with industry-leading lead times, and it is only beginning to tap its opportunity, having just signed its first master service agreement with a hyperscale customer. The company has invested heavily in capacity and people to support future growth. Given strong demand, its planned manufacturing footprint has grown to $5.8 billion, up from prior levels. We expect many years of strong growth and margin expansion as Forgent grows into that footprint.

Mercury Systems, Inc. is a technology company that supplies processing subsystems, ruggedized electronics, and mission-critical components to aerospace and defense prime contractors and the U.S. government. The company’s shares declined amid increasingly negative sentiment toward the defense sector, driven by concerns about the implications of a potential change in congressional control following the mid-term elections. Mercury has exposure to key national defense programs, including missile defense systems such as Patriot, electronic warfare systems, and ruggedized, high-speed data processing systems. We believe the company is positioned for accelerated growth for the foreseeable future as the programs it supports ramp production considerably over the next few years.

The top 10 holdings in the Fund represented 30.4% of net assets. We expect the top 10 holdings to represent about 30% of the portfolio over time.

We initiated a position in Madison Air Solutions Corporation, a leading HVAC manufacturer that came public earlier this year. The company generates high single-digit organic revenue growth, industry-leading EBITDA margins (in the high 20s), and excellent free cash flow. Most of its revenue is tied to commercial HVAC, including a sizable data center cooling business. In August, the company reported a robust $2.9 billion order backlog and a 1.3 times book-to-bill ratio, illustrating the strong fundamental tailwinds the company is experiencing.

Also in August, the company announced a $5.4 billion transformative acquisition of German airflow provider ebm-papst for around 15 times EBITDA. We believe the acquisition is a perfect fit, as ebm’s electronically commutated motor (ECM) fan technology is a fast-growing but underpenetrated part of the HVAC ecosystem, and we believe ebm can grow organically at a high single-digit rate given its attractive end-market exposure. That said, ebm’s EBITDA margins are below those of the core Madison Air business, and that, combined with an equity raise to finance the deal, led to a steep sell-off in the shares.

We think the sell-off is overdone. The Madison Air team has a strong track record of integrating acquisitions and rapidly improving target margins. Management has discussed roughly 25% EBITDA margins for the entire business by 2029, which implies they can get target margins up from 12% to 19% by 2029, in line with previous integrations. Contrary to the market’s reaction, we believe the Madison Air/ebm combination has created a stronger, faster-growing HVAC compounder that can become a much larger company over time.

During the quarter, we initiated a position in Spotify Technology S.A., the world’s leading audio streaming platform, with over 750 million monthly active users and nearly 300 million paying Premium subscribers. Its advantages include unmatched global scale, the deepest personalization engine in audio (now powered by a proprietary Large Taste Model fed by 3.4 trillion daily taste signals), product specialization, and a two-sided network connecting listeners with artists and creators. Its share of global paid subscribers is more than double that of the nearest competitor. Scale funds better personalization, which drives engagement and retention, which strengthens Spotify’s hand with record labels and its appeal to advertisers.

Spotify has recently shown that its model can deliver high margins and robust cash flow. In 2025, gross margin reached a record 32.0% in the quarter, operating income rose to €2.2 billion at a 13% margin (from 9% a year earlier), and free cash flow grew 27% year-over-year to €2.9 billion. We believe it is still early in a durable monetization and margin expansion story. Spotify has raised U.S. prices three times in four years with minimal churn while expanding into higher margin podcasts and audiobooks. It plans to add offerings such as “Reserved” concert ticket access, fitness content, and AI creation tools. The most ambitious is Studio, the first standalone app in its 20-year history. Studio is a media player for the generative age that connects (with permission) to a user’s calendar, inbox, notes, and feeds to generate personalized audio saved directly to their Spotify library. Spotify brings the distribution and daily engagement to scale it quickly. At the current valuation, upside from new TAMs such as Studio and Fitness is effectively a free call option.

At its May 2026 Investor Day, management set 2030 targets of a mid-teens revenue CAGR, 35% to 40% gross margin, and an operating margin above 20%, with longer-term ambitions of 1 billion subscribers and $100 billion in revenue. With mid-teens revenue growth compounding on expanding margins, we expect earnings and free cash flow to grow more than 20% annually for the foreseeable future.

During the quarter, we initiated a position in Jersey Mike’s Subs Inc., a franchisor of fast casual, submarine-style sandwich restaurants. It is one of the largest and fastest-growing limited-service restaurant brands in the U.S., with nearly 3,400 stores across all 50 states and Canada, nearly all franchised. The system generated $4.3 billion in sales in 2025, and its loyalty program has more than 12 million members.

Jersey Mike’s pairs a premium, made-to-order product with one of the simplest and most efficient operating models in quick service. Subs are made in view of guests on a standardized 14-foot line, supported by a distribution model for core ingredients, and a hot grill menu (including Philly cheesesteaks) differentiates it from other sub chains. The brand ranked number one in quick-service customer satisfaction in the American Customer Satisfaction Index for 2026 and has 90% aided brand awareness, both rare for a chain of its size. The store format reinforces the advantage: new units are small (1,200 to 1,400 square feet), need no drive-thru, and cost about $515,000 to build. With average unit volumes of $1.4 million, franchisees earned a 2.6 times sales-to-investment ratio and roughly 42% cash-on-cash returns in fiscal 2025. A strong owner-operator culture, including about 360 hours of franchisee training and existing owners accounting for more than 90% of the development pipeline, together with a $200 million national ad fund, would be very difficult for a competitor to replicate at scale.

We expect systemwide sales to keep growing at a double-digit pace over the next several years, following an 18% annual growth rate from 2021 to 2025. Growth should come from 8% to 10% annual unit growth toward a long-term potential of 7,500 U.S. and 15,000 global stores, positive same-store sales (20 consecutive years, 3.2% in 2025), and average unit volumes that have compounded at roughly 6% a year since 2006. As a capital-light franchisor, the business generates adjusted EBITDA margins above 50%, with capital expenditures of just $4 million in the first half of 2026. We believe the shares are very attractively priced and offer the opportunity for strong appreciation from here.

Natera, Inc. is a diagnostics company that provides tests in oncology, women's health/non-invasive pre-natal testing and organ health. We view the company as a leader in many of its testing areas, including oncology, where its Signatera personalized blood test for cancer recurrence assessment, monitoring and treatment response is growing rapidly. We sold the investment as we viewed valuation to be extreme on even a long-term basis but would revisit it at more appropriate valuation levels.

We exited our position in Wynn Resorts, Limited, an operator of hotel and casino resorts, in order to initiate a new position in Texas Roadhouse, Inc., a casual dining restaurant operator.

We sold our position in SiteOne Landscape Supply, Inc., a distributor of landscape supplies, to buy Madison Air Solutions Corporation, as discussed above.

We are very excited about the prospects for all of our portfolio investments. In particular, we believe that our aerospace investments should recapture lost multiples once conditions normalize in the Middle East. And our defense investments (which are particularly undervalued) should rebound once the air clears after the mid-term elections in November. Finally, we think that the sell-off in consumer stocks is overdone, and that we are in a unique period in which to invest in high growth, high-quality consumer companies trading at trough valuations.

Thank you for investing with us!