Fund Performance

Royce Total Return Fund finished the calendar year with a gain of 1.3%, behind its small-cap benchmark, the Russell 2000 Index, which was up 4.9% for the same period. This was a discouraging outcome even as the Fund in many ways performed as we would expect it to. The last four years have been characterized by both declining volatility and higher-than-average small-cap returns. In such a climate, we would anticipate beating the index in downdrafts while trailing in upswings, which has pretty much been the case for the 2011-2014 period, a span during which Total Return achieved solid results on an absolute basis with noticeably lower volatility than its benchmark. Yet this has not made its frequent periods of underperformance any easier for us to digest.

The year began with lower but positive small-cap returns following a highly dynamic 2013. The Fund trailed its benchmark in the first quarter before outpacing it in the second, finishing the first half with a 2.7% gain versus 3.2% for the Russell 2000. Small-caps established a high on July 3 that would hold until late December. The third quarter turned quickly bearish, and during this period the Fund held its value more effectively than the small-cap index, losing 6.5% versus 7.4%. Helped by a holiday gift in the form of a robust rally spread over most of the end of December, the fourth quarter was highly bullish. Total Return finished the closing quarter up 5.5%, a more-than-respectable showing that nonetheless trailed the even more impressive 9.7% advance for the Russell 2000. Another year with a relative performance disadvantage affected longer-term results, pushing the Fund's edge further out. Total Return outpaced its benchmark for the 15-, 20-year, and since inception (12/15/93) periods ended December 31, 2014. The Fund's average annual total return since inception was 11.2%, a long-term record that gives us great pride.

What Worked... And What Didn't

Six of Total Return's 10 equity sectors made positive contributions to 2014's results, with Financials leading a diverse list that also included Health Care, Utilities, Information Technology, Consumer Discretionary, and Telecommunication Services. Three of the Fund's four bestperforming industries are housed within Financials—insurance companies, real estate investment trusts (REITs), and capital markets stocks. REITs, one of the strongest areas for small-caps in 2014, is not an area of primary investment focus, and we were significantly underweight versus the Russell 2000. Net gains came from a large number of companies in these three groups, led by long-term holding and top position Erie Indemnity, a Pennsylvania-based insurer whose shares we have held in the portfolio since 1998. A strong fiscal second quarter keyed an autumn advance for its shares.

From the Health Care sector, Chemed Corporation operates two different businesses—hospice care provider Vitas and plumbing and drain cleaning service company Roto-Rooter. Its shares seemed to climb mostly as a result of a "no news is good news" scenario concerning Vitas. In 2013 the Justice Department began looking into its Medicare enrollment and billing rates. Offering more critical care than is typical in the hospice industry may have helped to trigger the investigation. However, margins for critical care are not much higher than for other elements of hospice care, and Vitas is one of the few able to deliver it on a nationwide basis. The lack of any additional developments in the investigation seemed to reassure investors. We reduced our position as its stock price rose. A rising share price also led us to take gains in The Cato Corporation, a discount women's fashion retailer that was nonetheless a top-20 position at the end of 2014. Improved same-store sales drove its recovery.

After a terrific first half, energy stocks fell so hard in the second half with the precipitous decline of oil prices that the sector became Total Return's hardest hit for the calendar year. Net losses in Consumer Staples, Materials, and Industrials especially had a decidedly less negative impact. While the near-term outlook for the energy industry remained very hard to gauge at this writing, we held shares in a number of companies, with our larger holdings typically slotted in the energy equipment & services group. The stock price of CARBO Ceramics, which manufactures ceramic proppants and other materials used in hydraulic well fracturing, fell more than 55% before the October announcement of better-than-expected earnings for the third quarter, news that did little for its share price. We added to our initially small position in Tidewater, which provides marine service vessels to offshore energy companies. Outside of Energy, we also built our stake in personal care products manufacturer and distributor Nu Skin Enterprises, which survived a multitude of recent challenges and is looking to revive its formerly fast-growing business in Asia.

Current Positioning and Outlook

While the market continued to show a preference for high yields in 2014, we still believe that steady, consistent dividend-payers offer long-term advantages. The Fund's sector weightings changed little from the end of 2013 as we again chose to position the portfolio for improved performance from cyclical sectors in 2015. We have based this decision on our confidence in both the ongoing expansion of the U.S. economy and an earnings-led rally for small-cap stocks.

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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