Royce Total Return Fund Performance Discussion

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

Royce Total Return Fund (RTR) gained 5.4% for the year-to-date period ended June 30, 2011, trailing its small-cap benchmark, the Russell 2000 Index, which was up 6.2% for the same period. The Fund was competitive with the small-cap index during the pleasantly bullish first quarter, up 6.4% compared to a gain of 7.9% for the Russell 2000.

The market began to reverse late in April, with stock prices falling from the interim small-cap high on April 29 through the downturn's low on June 13, a period that saw RTR fall 7.2% compared to a decline of 10.1% for its benchmark. Stocks then rallied for much of the rest of June, undoing some of the damage the bear's brief visit created. For the second quarter, the Fund was down 0.9% while the Russell 2000 dropped 1.6%. We were pleased, then, to see RTR defend well when share prices were falling and remain close to the small-cap index during more bullish periods.

Recent market cycle returns saw a similar pattern. From the small-cap peak on July 13, 2007 through June 30, 2011, the Fund climbed 3.7% while its benchmark was up 2.2%. In the more bullish phase from the interim small-cap low on July 6, 2010 through the end of June 2011, RTR gained 33.1% versus 41.9% for the Russell 2000. (More on the Fund's results over recent market cycles.)

Although our affection for them has never diminished, we have been disappointed that dividend-paying small-cap and micro-cap stocks have lagged since the last small-cap peak in July 2007. Still, the Fund's long-term results were strong on both an absolute and relative basis. RTR outperformed the Russell 2000 for the five-, 10-, 15-year and since inception (12/15/93) periods ended June 30, 2011. The Fund's average annual total return since inception was 11.3%.

We have long held that the practice of paying dividends is an excellent measure of a company's underlying quality. As the U.S. economy has moved from recovery mode to a more modest and uneven expansion, the importance of quality is becoming clearer to investors. Recovery typically benefits weaker companies first as they have the most to lose if a recession persists.

However, higher-quality companies are more often rewarded as economies begin to grow again. In fact, many measures of quality such as earnings growth and internal rates of return characterize those companies that have been the leading performers in the market over the past several quarters. Although dividend-payers have not been rewarded recently, we think that a lack of yield elsewhere combined with a shift in investors' risk preferences should benefit these companies going forward.

Pleasing to us as we parsed RTR's return composition was the fact that all 11 equity sectors contributed positively in the first half. Industrials and Energy were the standout performers, with Consumer Discretionary the third-largest contributor. From an industry standpoint, finite resource companies were disproportionately represented as the combination of increasing global importance of emerging economies and the ongoing debasement of the world's leading currencies helped to keep commodity prices at elevated levels. Energy equipment & services, specialty retail and machinery were the top industry groups, along with a strong showing from chemicals. On the negative side, capital markets, media, and communications equipment companies provided modest drags.

The Fund's top five contributors came from either the Energy or Consumer Discretionary sectors. CARBO Ceramics, a long-time Royce holding, was the leading performer in the period. CARBO produces ceramic proppants used in horizontal shale drilling and has benefited from extremely strong pricing in this supply constrained commodity critical to the success of shale wells. Wolverine World Wide, a manufacturer and marketer of a broad range of branded footwear including both casual and work shoes, saw a healthy increase in sales with excellent expense management that propelled both earnings and its stock price higher. With well-known brands such as Merrell, Hush Puppies and Wolverine, as well as global distribution, the company is well positioned for both nearand longer-term growth, especially as brand recognition becomes increasingly important to the emerging consumer.

While RTR was able to generate a small gain in aggregate from its positions in Financials, the Fund's largest sector also produced three of the top four detractors. Credicorp, a bank and insurance holding company based in Peru, saw its share price decline as political uncertainty followed the recent presidential elections, which led to a downgrading of investor expectations for the Peruvian economy. PartnerRe, a multi-line reinsurance company based in Bermuda, was negatively affected by the large number of insured events in the period, specifically the May tornadoes and the New Zealand earthquake. While there have clearly been some losses in the short run, our expectation is for improved premium pricing over the next cycle.

The sum of all contributions to and detractions from performance for all securities would approximate the Fund's year-to-date performance for the period ended June 30, 2011.

See our June 30, 2011 Semiannual Review and Report to Shareholders for a complete list of holdings for Royce Total Return Fund as of June 30, 2011.
View the complete list of holdings for Royce Total Return Fund as of the current quarter end.

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