Royce Partners Fund Performance Discussion

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

Royce Partners Fund (PTR) is one of a select group of Royce offerings with its roots firmly entrenched in the smaller company universe while also having the flexibility to pursue opportunities up and down the capitalization spectrum. With our view that leadership in the market will most likely rotate between small-cap and large-cap stocks over time, we see this flexibility as having great value.

We use the same rigorous analytical standards of strong balance sheets, high internal rates of return and appropriate valuation and long-term investment horizon that have come to define our disciplined approach over nearly four decades. So while a large portion of the portfolio will continue to be sourced from our favored segment of smaller companies, the opportunity exists to take advantage of market dislocations and above-average volatility to apply our methodology to companies of all sizes. In the volatile first half of 2011, PTR fell behind its benchmark, advancing 4.4% compared to the Russell 2500 Index, which rose 8.1% over the same period.

While the performance of many corporations exceeded our expectations in 2011's first half, many of the same structural problems that plagued the first half of 2010 resurfaced to shake investor confidence. The weaker periphery of Europe was once again front and center as sovereign financing costs went higher and few substantive solutions were put forth from either the ECB or Euro zone leaders. China continued to tighten credit as inflationary pressures added to risks that this increasingly important global economy was getting closer to overheating.

Here in the U.S., supply chain disruptions following the Japanese tsunami and a consumer pinched by higher oil prices led to renewed fears that the recovery was on shaky footing, particularly as the Fed's program of quantitative easing drew to a close. Stalled negotiations on the debt ceiling and a Congress unable to construct a viable plan for debt reduction also weighed on the minds of investors leading to a mid-quarter correction of roughly 10%.

In the strong first quarter, PTR produced a decent absolute return of 5.9%, though it was behind the Russell 2500's 8.7% advance. The second quarter, which included the very difficult month of May followed by a partial recovery in June, also saw PTR underperform its benchmark, albeit more modestly. PTR fell 1.4% compared to the index, which fell 0.6%. Since its inception at the tail end of the financial crisis, the Fund has lagged its benchmark owing in large part to a cautious investment stance in what turned out to be the beginning of a powerful recovery from the bear market lows.

Five of the Fund's eight equity sectors were in positive territory in the first half, with far and away the biggest contribution from the Information Technology sector. While this sector was in the middle of the pack in its contribution to the benchmark's overall return, three of PTR's top four performing investments came from this important sector.

Industrials and Consumer Discretionary were the next best contributors while Financials and Diversified Investment Companies were the Fund's two weakest sectors. Financials also continued to be a drag on performance for the Russell 2500 Index, finishing in last place there as well. While PTR has limited exposure to banks, where most of the negative headlines still persist, our favored industry, capital markets, also struggled in the period as investor flows into equities turned negative during the market's drawdown, affecting several of our investments in asset managers. On the other hand, three investment management companies were among the Fund's top-ten contributors—Cohen & Steers, Ashmore Group and VZ Holding.

IPG Photonics, a leading manufacturer of fiber lasers and amplifiers experienced continued expansion in end markets for fiber laser technology. Already surpassing 2008 peak earnings levels, we believe that accelerating expansion in global end markets combined with IPG's first mover advantage in numerous laser applications leaves the company well-positioned for continued success.

ServiceSource International offers several technology products that assist customers in maximizing and growing renewal rates from maintenance, support and subscription agreements. Benefiting from increasing use of cloud-based solutions for service revenue management, ServiceSource saw it share price appreciate nicely, commensurate with increasing expectations for growth in its earnings profile.

Value Partners Group, a leading value-based asset manager focusing on China and the greater Asia-Pacific region, saw its share price decline as continued interest rate increases by China's monetary authority weighed on regional share prices broadly. We continue to be very constructive on the company as growth opportunities abound in this relatively under-serviced region of the asset management world.

Patriot Transportation Holding, which boasts a unique combination of transportation and real estate businesses, reported lackluster earnings. A long-term holding for Royce, Patriot has a very strong balance sheet, is seeing gradual improvement in its various lines of business and possesses what we believe are substantially under-valued assets.

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