Royce Select Fund II Performance Discussion

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

More volatility, greater uncertainty and added anxiety led to lower returns for Royce Select Fund II (RS2) during the first half of 2011. During the semiannual period ended June 30, 2011, the Royce Select Fund II lost 3.4% versus gains of 6.2% for its domestic benchmark, the small-cap Russell 2000 Index and 2.5% for its new small-cap global benchmark, the Russell Global Small Cap Index, for the same period.

During the bullish first quarter, RS2 was up 4.2%, trailing its domestic benchmark's rise of 7.9%, but ahead of the global small-cap index, which rose 3.2%. When stock prices began to correct in late April, the Fund struggled on both an absolute and relative basis. RS2 fell 12.6% from the domestic high on April 29, 2011 through the 2011 correction's low on June 13 compared to a drop of 10.1% for the Russell 2000 and a decline of 7.2% for the Russell Global Small Cap.

For the second quarter, RS2 fell 7.3%, again underperforming—the Russell 2000 declined only 1.6%, while the global small-cap index was down 0.7%. This was a disappointing outcome because negative returns are always discouraging, as is underperformance versus the benchmark.

Many of the Fund's losses came from small-cap and micro-cap U.S. listed companies that are based in China or derive a large portion of their businesses from China. These companies suffered from guilt by association, pressured by accounting irregularities at another U.S. listed firm. We found that in most cases, other investors ignored the fact that most of these companies continued to execute successfully and had no accounting issues of their own. In this more global context, we want to mention that as of May 1, 2011 the Fund may invest in U.S. and/or foreign securities, and there is now no limit to the Fund's foreign exposure. This explains why we have added a global benchmark.

From the domestic market low on March 9, 2009 through June 30, 2011, RS2 gained 138.5% compared to a gain of 148.6% for the Russell 2000 and 146.0% for the Russell Global Small Cap. The Fund was also behind both indexes from the interim domestic small-cap low on July 6, 2010 through the end of 2011's first half, climbing 25.9% versus respective gains of 41.9% and 33.5% for the Russell 2000 and Russell Global Small Cap. RS2 did outpace both  the domestic and global small-cap indexes for the three-year, five-year and since inception (6/30/05) periods ended June 30, 2011. The Fund's average annual total return since inception was 7.8%.

Year-to-date through the end of June, four of the Fund's nine equity sectors were in positive territory. Energy led all sectors, followed by Consumer Discretionary. At the industry level, the energy equipment and services made the most sizable positive contribution. Industrials was the worst-performing sector for the semiannual period by a wide margin. The sector was particularly sensitive to investors' growing concerns about a host of issues, including global debt, the viability of the U.S. economy's recovery, and a potential slowdown in China. The electrical equipment industry was the greatest detractor at the industry level.

FamilyMart was the Fund's largest holding at the end of the period and is the third largest convenience store chain in Japan. FamilyMart has strengthened its presence in the Tokyo metropolitan area and expanded aggressively in Asia, focusing on the Taiwanese, South Korean, and Chinese markets.

SMART Modular Technologies (WWH) was the greatest contributor to performance in the first half. Headquartered in Fremont, California, the company manufactures value-added subsystems to computer and communications OEMs (original equipment manufacturers). The company announced that it was being acquired by Silver Lake Partners in May. We sold our shares shortly after the announcement.

Helmerich & Payne was another top contributor to performance in the first half of 2011. A contract driller that provides offshore drilling services worldwide and land drilling in the U.S., its stock price moved around quite a bit during the year's opening half, as oil prices were very volatile. However, it finished June near its 2011 high, due in large part to demand for its innovative services and the company's large number of new, modernized rigs that offer both higher safety and increased efficiency. We were impressed that management chose to upgrade its rig supply when most competitors were content to refurbish theirs.

As mentioned, each of the Fund's five major detractors were companies that are based in or that derive much of their business from China. We parted ways only with Harbin Electric, an electric motor manufacturer in China, that was the greatest detractor to performance by a wide margin and is currently no longer in the portfolio. Early in July, we sold our position in China Green. We added to our positions in copper-clad wire and cable maker Fushi Copperweld and real estate services business E-House China Holdings.

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