A relatively slow start to 2014 led Royce Special Equity Multi-Cap Fund to lose some ground to its benchmark in the first half. The Fund advanced 5.3% for the year-to-date period ended June 30, 2014, trailing its benchmark, the Russell 1000 Index, which increased 7.3% for the same period.

The second half of 2013 was a highly bullish period, though one in which leadership remained with lower-quality stocks. This has mostly remained the case so far in 2014. For the first quarter, the Fund was up 0.6% versus a gain of 2.0% for its benchmark. The Fund’s underweight in Utilities and overweight in Consumer Discretionary had a negative impact on first-quarter returns. It has not been pleasant to be overweight in the latter sector so far in 2014. However, we believe that as the economy continues to improve (as we believe it will), results should improve, perhaps dramatically. The outlook for consumer spending looks healthy as a result of tame inflation, still restrained mortgage rates, rising household net worth, repaired household balance sheets, and improved consumer confidence. In addition, capacity utilization in the U.S. is inching towards the 80% rate; at this level we should start to see more hires and capital expenditures, reigniting the economy.

Large-cap performance was in general more consistent in the first half, not correcting as small-caps did from early March through mid-May. For the second quarter, the Fund gained 4.7%. In addition to posting strong results on an absolute basis, Special Equity Multi-Cap continued to hold a relative advantage over its benchmark for the three-year and since inception (12/31/10) periods ended June 30, 2014. The Fund’s average annual total return since inception was 16.7%.

The market is much narrower than it has been in the recent past, with greater stock selection at work, which should help the Fund’s results in time. Through April 24, the top 10 contributors in the S&P 500 equaled 99.3% of the large-cap index’s advance, while for the same period last year it was only 25.3%, which shows the narrower focus. Many have observed that for a validation of the improving prospects for the economy, rates on Treasuries should be rising. They have not as of yet. This is an interesting point, as it suggests that rising rates, due to stronger economic activity, will not weigh down the market. We believe we are close to a move towards greater cyclical exposure in the marketplace. We think that investors will increasingly abandon their obsession with counter-cyclicals and start to embrace anything with economic leverage in the U.S.

Consumer Discretionary stocks remained the portfolio’s most significant detractors for the entire first half, its largest net losses coming from the specialty retail industry. The sector’s losses as a whole were mitigated by robust results for multiline retailer Nordstrom, which bucked the trend for its own industry as well as that of specialty retailers, and Lear Corporation, a maker of automotive seating, electrical distribution systems, and related components primarily to automotive original equipment manufacturers. Each of these companies was among the Fund’s larger positions at the end of the first half. The Fund's fifthlargest holding at the end of June, Bed, Bath & Beyond led all detractors. We increased our position throughout the first half in this New Jersey-based retailer of a wide variety of domestic merchandise. Office products retailer Staples was also a large detractor from performance through the end of June, hurt by poor sales.

While holdings in the Energy and Health Care sectors posted more-than-respectable net gains in the first half, the Information Technology sector was a source of particular strength, contributing most to results for the semiannual period. Four tech-based names stood out with impressive net gains—SanDisk Corporation, KLA-Tencor, Microsoft Corporation, and Cisco Systems. The stock making the most significant positive impact, however, came from the Energy sector. Helmerich & Payne is a contract drilling company in North and South America that provides drilling rigs, equipment, personnel, and camps on a contract basis. The stock of this Tulsa, Oklahoma-based business appeared to benefit from growing demand for its services in a brisk market for energy services companies.

An economic outcome that we increasingly believe in resembles Bill Gross’s “new neutral:” Slower but more consistent growth than we have seen in the past with resulting lower-thanexpected inflation and interest rates. This is a variation of the “Goldilocks” outcome—not too hot or too cold. If this is indeed the case, P/E multiples will likely stay at current levels and possibly even increase.

Average Annual Total Returns as of Quarter-End 6/30/14 (%)

Annual Operating Expenses: Gross 1.46% Net 1.24%

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

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