Commentary

Chris Clark

We sat down recently with Chris Clark to get his take on the Royce Select Funds, four portfolios that are available only to high net worth individuals and institutions that meet the SEC's definition of "qualified investors."

The portfolios are Royce Select Fund I, Royce Select Fund II, Royce Global Select Fund and Royce SMid-Cap Select Fund.

The last 20 years have seen a proliferation of investment vehicles for institutional and high-net worth individual investors. Royce first participated in these activities when we introduced Royce Select Fund I in November of 1998. That Fund established the template that we now use in all four funds.

The Funds' fee and expense structure is tied directly to total returns. Royce based the structure on financial products that originated in the 1980s, which indicated that true performance fees were perhaps more palatable than flat fees for qualified investors. Each of the Royce Select Funds pays a management fee to Royce equal to 12.5% of its respective pre-fee total return to a performance peak. Royce absorbs all other ordinary expenses of the Fund, other than the dividend expense relating to short selling and "acquired fund" fees and expenses. The Fund's management fee is subject to a daily high watermark, which means that Royce will only receive a fee during periods of positive performance from a prior peak for the Fund.

If the total return recedes from the high watermark, no fee will be taken until the Fund's pre-fee total return once again exceeds the high watermark. We think the Select Funds' fee structure offers a distinct advantage—during low-return periods, the expenses have a much more modest impact on returns, and during  negative-return periods, there are no management fees or operating expenses charged to the Fund.

The Funds also offer some flexibility in their portfolio structure—each may establish short positions representing up to 35% of their respective net assets. In addition, the Funds may employ leverage. Each Select Fund may borrow from banks in an amount that does not exceed one-third of the value of its respective total assets and may borrow from other entities for temporary purposes in an amount that doesn't exceed 5% of the value of their respective net assets.

In our view, this gives qualified investors something of the best of both worlds—the transparency and liquidity of a publicly traded mutual fund along with some of the flexibility of a hedge fund.

Chuck Royce co-manages Royce Select Fund I with Lauren Romeo, Royce Select Fund II with James Harvey and Royce SMid-Cap Select Fund with Steven McBoyle. Whitney George co-manages Royce Global Select Fund with David Nadel. Each portfolio thus features a team that includes one of our most experienced managers along with a member of our newer generation of portfolio managers.

Each Select Fund seeks long-term growth of capital and invests in both long and short positions in equity securities. The long portion of each Fund's portfolio is primarily invested in a limited number (generally less than 100) of smaller companies, those with market capitalizations up to $5 billion.

Royce Select Fund I focuses on smaller companies that possess excellent business strengths and/or prospects, high internal rates of return and low leverage.

Royce Select Fund II also seeks companies with excellent business strengths and/or prospects, high internal rates of return and low leverage. In addition, Royce may attempt to take advantage of what it believes are opportunistic situations for undervalued securities, such as turnarounds, emerging growth companies with interrupted earnings patterns, companies with unrecognized asset values or undervalued growth companies.

Royce Global Select Fund invests the long portion of its portfolio primarily in a limited number of U.S. and foreign micro-, small- and mid-cap companies that possess excellent business strengths and/or prospects, high internal rates of return, and low leverage.

Royce SMid-Cap Select Fund invests primarily in small- and mid-cap equity securities that Royce believes are trading below its estimate of their current worth, putting primary emphasis on balance sheet quality, cash flows and various internal returns indicative of profitability, and the relationships that these factors have to the price of a given security.