In the first quarter of 2026, the Baron SMID Cap ETF (BCSM) experienced a notable decline, underperforming its benchmark. This period was characterized by a significant market shift, with investors heavily favoring companies perceived as direct beneficiaries of artificial intelligence (AI) advancements and electrification. Concurrently, businesses not immediately classified as AI 'winners' faced considerable selling pressure, regardless of their intrinsic performance. This market behavior, amplified by algorithmic trading strategies, created a challenging landscape for the fund's bottom-up investment approach, where robust company results often went unrewarded.

Baron Capital's SMID Cap ETF, managed by Laird Bieger and Randy Gwartzman, builds upon the successful investment philosophy of the Baron Discovery Fund. The ETF targets small and mid-sized growth companies, emphasizing businesses with substantial long-term growth potential, distinct competitive advantages, and exceptional management. The managers prioritize firms with high-quality, recurring revenue streams and strong profit margins, believing these characteristics are crucial for sustained outperformance across various market cycles. Their expanded mandate allows for initial investments in slightly more mature companies than the Discovery Fund, yet both uphold a rigorous, quality-first investment process designed to identify undervalued opportunities.

The investment strategy, termed 'investing in reverse,' focuses initially on identifying companies that meet stringent quality criteria—fast-growing, high-margin businesses with promising long-term outlooks. Only after establishing a 'shadow list' of these high-quality firms do the managers consider valuation. This patient approach allows them to capitalize on market dislocations or company-specific setbacks that temporarily depress stock prices, creating opportune entry points for long-term growth. This contrasts with conventional methods that often prioritize valuation screening, potentially overlooking high-quality businesses temporarily trading at premium prices.

Risk management is an integral component of BCSM's strategy, centered on portfolio construction and capital protection during market downturns. The fund's sector exposures generally align with the Russell 2500 Growth Index, aiming for alpha generation primarily through individual stock selection rather than broad sector bets. The portfolio is diversified across three growth profiles: 'high growth' for earlier-stage, innovative companies; 'growth' for more established, free cash flow-positive businesses; and 'other' for less market-correlated entities, including special situations or 'fallen angels' with temporary price declines. This balanced approach is intended to mitigate portfolio volatility.

During the challenging first quarter, the software industry significantly impacted BCSM's relative performance, accounting for approximately half of the underperformance. Many software holdings, despite delivering strong earnings and raising future guidance, saw their stock prices decline over 30% due to being miscategorized as AI 'losers.' The managers argue that certain software categories, such as those leveraging deterministic data, specialized vertical expertise, or integrated physical products, are robust against AI disruption. Conversely, the fund benefited from investments in AI 'winners' like Coherent Corp. and Lattice Semiconductor Corporation, which demonstrated strong performance amidst the AI-driven market enthusiasm.

In terms of portfolio activity, BCSM initiated a position in Waystar Holding Corp., a healthcare revenue cycle management software provider, recognizing its AI-driven solutions and attractive valuation. The fund increased its stakes in Samsara Inc. and Dynatrace, Inc., both considered 'atoms plus electrons' winners in software, leveraging proprietary data and AI models for competitive advantage. Guidewire Software, Inc. also saw increased investment, with the managers viewing AI as a tailwind for accelerating product releases and reducing implementation costs. Conversely, positions in Kratos Defense & Security Solutions, Inc. were sold after reaching valuation targets, and Flutter Entertainment plc was exited in favor of DraftKings Inc., which offered higher growth and a vertically integrated prediction markets exchange.

Despite the recent volatility, the underlying fundamentals of BCSM's portfolio companies remain robust. The management team believes that short-term market divergences from fundamental business performance are unsustainable. Over the long term, stock prices are expected to reflect future free cash flows, especially for companies combining high growth with strong cash generation. The fund is positioned to benefit when the market eventually shifts its focus back to fundamental performance, moving beyond the transient AI 'winner versus loser' narrative.