Fund Performance

Royce Micro-Cap Opportunity Fund (formerly Royce Opportunity Select Fund) finished the year with a loss of 5.0% in 2014, underperforming its small-cap benchmark, the Russell 2000 Index, which increased 4.9% for the same period. After two consecutive calendar-year performances that were strong on both an absolute and relative basis, Micro-Cap Opportunity finished much farther behind its benchmark than we would like. A year in the red is far from ideal, but we remain confident in the Fund's distinctive opportunistic approach.

For the first half, the Fund narrowly outpaced the Russell 2000, up 3.3% versus 3.2%. The bulk of Micro-Cap Opportunity's difficulties, on both a relative and absolute basis, thus began in the bearish third quarter when small-caps began to slide following a high on July 3. For the quarter, the Fund fell 10.7% compared to a loss of 7.4% for the small-cap index. While the Fund underperformed in the bullish fourth quarter, rising 3.0% while the Russell 2000 climbed 9.7%, the quarter included the end of the downturn, which bottomed out on October 13. From that date through the end of December, Micro-Cap Opportunity did well on an absolute basis, advancing 12.3%. Longer-term results remained strong on an absolute basis though they were more mixed vis-à-vis the benchmark. The Fund outpaced the Russell 2000 for the three-year period ended December 31, 2014. the Fund's average annual total return since inception (8/31/10) was 17.3%.

What Worked... And What Didn't

The market hates uncertainty. So it was not surprising to see an exogenous event—in this case, the collapse of oil prices—sow the seeds of uncertainty and help to create both higher volatility and steep losses, at least among certain small-caps and most energy companies. Micro-Cap Opportunity was overweight in Energy compared to the Russell 2000 at the end of June. Though otherwise modest, exposure was just large enough for the sector to register the largest net losses in 2014 (though net losses for Materials were nearly identical). Offshore drilling has higher costs, which usually means being hurt first and hardest in any decline for crude oil prices. This was bad news for Hercules Offshore, which provides shallow-water drilling and marine services to oil and natural gas companies. It also meant a rapidly plunging share price for Swift Energy, an onshore and offshore exploration & production ("E&P") company. We sold our shares in each as part of the effort to significantly pare back the portfolio's sector weighting, which stood at just 1.5% of the long portfolio at the end of December. We chose to hold a small position in Canadian E&P business Pengrowth Energy at year end, along with a handful of other Energy businesses.

Extreme Networks provides switching solutions for local area networks (LAN). Disappointing earnings, based in part on lowerthan- expected sales to government entities, and revised guidance drove investors away. We liked its acquisition of a complementary business, which we think can help the company to improve earnings, though this is admittedly taking longer than we anticipated. After building a position in the first half, we reduced it during the year's last six months. We went the opposite way with Quiksilver, reducing our stake in the first half before adding shares in the second. An earnings miss in June sent its shares careening down more than 40%. The company makes and distributes youth-oriented branded apparel, footwear, and accessories. Its turnaround is also taking longer than we anticipated, but we like the management team that came on board in 2013 and the strong presence of its brands in high-profile spots such as Macy's.

In February 2014, RF Micro Devices and TriQuint Semiconductor agreed to merge, which seemed to help the shares of each semiconductor business to climb in 2014. Our attraction to RF Micro Devices, which makes radio frequency (or RF) chips primarily for wireless applications, was a play on the wireless flash segment in the mobile handset market. We sold the last of our shares of TriQuint in February while holding a large position in RF Micro Devices at year end. (In January 2015, the merged company became known as Qorvo.) Finally, the portfolio's short positions had an aggregate negative effect on performance that was slightly larger than the net losses from the Information Technology sector, though well behind the net losses for Energy and Materials.

Current Positioning and Outlook

In many ways a restocking year, 2014 saw us trimming or selling positions that had established momentum while looking to find or add to companies that will ideally furnish the next few years with strong performance. Looking ahead, we are constructive on several consumer and technology areas, as well as housing and non-residential construction. Lower energy prices and improved employment rates should help to keep the U.S. consumer active and confident. We anticipate that housing sales should gain momentum following the Super Bowl, as is often the case, and also expect non-residential construction and infrastructure activity to increase in 2015.

Average Annual Total Returns as of Quarter-End 12/31/14 (%)

* Not Annualized

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

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