Royce Financial Services Fund Performance Discussion

This discussion comes from our June 30, 2011 Semiannual Review and Report to Shareholders.

Financial stocks of all kinds were subject to the volatility that affected the stock market as a whole through the first six months of 2011, and Royce Financial Services Fund (RFS) proved no exception. The Fund was up 2.6% for the year-to-date period ended June 30, 2011, trailing its smallcap benchmark, the Russell 2000 Index, which gained 6.2%, and the financial services component of the Russell 2500 Index, which climbed 2.6%, for the same period. This was a discouraging result, in particular on a relative basis, though in the end it was not terribly surprising.

The Fund's selections within the financial sector, which we will discuss in more detail below, nearly guarantee that it will be out of sync over shortterm periods, both with its small-cap benchmark and the index that measures the performance of micro-cap, small-cap and mid-cap financial services stocks.

The year can thus far be divided into two contrasting periods. The first four months consisted of a mostly uninterrupted bull run. The final two, however, were marked by considerable volatility, including a 10.1% decline for small-cap stocks between April 29 and June 13 that was followed by a dynamic rally.

Although welcome, the upswing did not bestow its favors equally throughout the market. The Russell 2000 Index rose 6.6% from the correction's low on June 13 through the end of the semiannual period, compared to a 3.8% gain for the financial services companies in the Russell 2500 Index (and +1.8% for the Fund). This lackluster result in the rally was a contributing factor to RFS's overall underwhelming performance for the period.

During the more placid first quarter, the Fund climbed 5.5%, trailing its benchmark's 7.9% gain, but ahead of the Russell 2500 financial services sector's +8.7% return. In the second quarter, RFS lost ground to both indexes, falling 2.8% versus losses of 1.6% for the Russell 2000 and 2.1% for the financial services companies in the Russell 2500 Index. Yet the Fund lost less than each index during the downturn from the 2011 small-cap high on April 29 through June 13, down 6.0% versus respective losses of 10.1% and 7.3% for its benchmark and the financial services component of the Russell 2500 Index.

Market cycle and other long-term performance periods were mostly solid on an absolute basis, but more mixed on a relative basis. From the market trough on March 9, 2009, RFS rose 123.1% versus gains of 148.6% for the Russell 2000 and 116.6% for the financial services companies in the Russell 2500. From the small-cap low on July 6, 2010 through the end of 2011's first half, the Fund was up 34.9% compared to respective gains of 41.9% and 26.4% for its benchmark and the financial services sector of the Russell 2500. Longer-term performance was decidedly in favor of RFS as it outperformed the latter for the one-, three-, five-year and since inception (12/31/03) periods ended June 30, 2011.

In selecting securities for the portfolio, we focus on conservatively capitalized financial companies that we believe are attractively undervalued, seeking those with low debt, high returns on invested capital, the proven ability to generate free cash flow and a history of earnings. Since RFS's inception, this has generally led us away from banks and toward businesses such as investment management, securities brokers and insurance. This remained the case at the end of June, when the portfolio's exposure to banks was low and the bulk of its net assets were in the capital markets industry. Unsurprisingly, then, this group was the Fund's best-performing industry for the semiannual period.

The top contributor in the first half was also 2010's most significant contributor and remained the portfolio's largest holding at the end of June. Virtus Investment Partners is a Hartford-based firm that operates a multi-manager asset management business. Growing sales and increased assets for two consecutive fiscal quarters seemed to draw other investors to the stock.

VZ Holding, another top-ten position, also enjoyed a strong opening half. A Swiss financial advisory firm that consults on investment, tax and inheritance planning, and insurance issues, its business was also robust through the end of June.

Cohen & Steers runs open- and closed-end real estate oriented mutual funds and institutional separate accounts. We have long admired the company's low debt and steady earnings. Also a top-ten position, the firm appeared to benefit from its rising revenues and strong earnings.

London-based Ashmore Group is a leading investment manager with a strong balance sheet and proven expertise in a variety of investments in developing markets, a status that created high demand for its shares. It was the Fund's second-largest holding at June 30.

We like the core business and longevity of asset manager and investment bank Egyptian Financial Group-Hermes Holding and increased our stake as events in Egypt helped to keep its stock price falling.

We also used the declining share price of Cowen Group to nearly double our position in April. The firm specializes in alternative investment management, investment banking, research and trading. A planned acquisition encountered legal snags earlier in the year, (since resolved) which hampered results.

Current month-end performance may be obtained from our Prices and Performance page.