article 10-07-2015

Market Reversals Are on the Horizon

Over the next five years we expect reversals resulting in historically below-average, single-digit results for equities, market leadership from profitable companies, renewed success for disciplined active management approaches, and small-cap value reasserting its traditional leadership role.

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A Stark Reminder—Stocks Can Fall
In their first decline since 3Q14, small-cap stocks experienced their largest drop since 3Q11. Still, since the March 2009 bear market bottom, we have seen only six quarterly declines through 26 quarters, 23% of the time, reflecting both the durability and low volatility of the current cycle. The depth of 3Q15's decline was historically on the high side, the twelfth-largest quarterly slide of the 51 down quarters since the inception of the Russell 2000 Index on 12/31/78.

Going In and Out of Style
The Russell 2000 Value Index lost less than the Russell 2000 Growth Index for the quarter, giving small-cap value its first quarterly outperformance since 2Q14. Small-cap value's superior performance in down quarters is "normal" insofar as it has beaten small-cap growth in 78% of down quarters for the Russell 2000. Unusually, since the March 2009 bottom, small-cap growth has performed relatively better in down quarters, outperforming small-cap value in 50% of the cycle's six quarterly declines.

Russell 2000 Down Quarters from 6/30/09 through 9/30/15

  Russell 2000 Value (%) Russell 2000 Growth (%) Spread between
Russell 2000 Value and
Russell 2000 Growth
9/30/2015 -10.73 -13.06 2.33
9/30/2014 -8.58 -6.13 -2.45
6/30/2012 -3.01 -3.94 0.93
9/30/2011 -21.47 -22.25 0.77
6/30/2011 -2.65 -0.59 -2.06
6/30/2010 -10.60 -9.22 -1.37

Sector Review—Low Energy and Poor Health
In the Russell 2000, the Energy, Materials, and Health Care sectors fared the worst for the quarter, though each of the small-cap index's 10 sectors were in the red. Net losses were driven by the economic growth scare and prescription drug pricing control concerns, as well as ongoing anxiety over China and the developing world. The best-performing sectors for the quarter—that is, those that lost the least—were Utilities, Consumer Staples, and Financials—all sectors with low economic sensitivity and a U.S. focus.

3Q15's Best and Worst Performing Sectors of the Russell 2000

Best Performing Sectors Worst Performing Sectors
Sector 3Q15 Returns (%)* Sector 3Q15 Returns (%)*
Utilities -0.3 Energy -32.8
Consumer Staples -4.8 Materials -21.9
Financials -5.3 Health Care -17.2

Market Capitalization Overview—More "Normal" Than Ever
We saw historically typical behavior for a down period—large-cap stocks, as measured by the Russell 1000 Index, held up best, followed down the market cap scale by the Russell Midcap, the Russell 2000, and the Russell Microcap. This was another signal that the highly anomalous markets of the last five years may be ending and giving way to more historically familiar performance patterns.

Geographic Survey—Europe Stays Strong
For the quarter, results for non-U.S. stocks were more mixed but generally stronger than those for the domestic indexes. European stocks held up better than any other region of the globe, while Asian and emerging market indexes were among the hardest hit.

YTD Leaders and Laggards—Growth Remains In Front
In spite of the tumultuous and volatile quarter, the Russell 2000 Growth remained well ahead of its small-cap value counterpart YTD through 9/30/15. Unsurprisingly, other YTD leaders included the Nasdaq Composite, companies based in developed Europe, and Health Care, though the latter was underwater YTD within small-cap. The YTD laggards included the Russell Microcap, Russell 2000 Value, Energy, and stocks in the Asia Pacific region.

Longer-Term Perspective—Returns Still Higher-Than-Average
Three- and five-year returns managed to stay above their historical averages at the end of 3Q15. The Russell Midcap was the leader over the Russell 2000, 1000, and Microcap Indexes while the Russell 2000 Growth led the Russell 2000 Value for the three- and five-year periods ended 9/30/15. The major domestic indexes were also ahead of their non-U.S. cousins for the three- and five-year periods (See below for complete returns).

Outlook—Looking for Reversals
Over the last several years, we have seen above-average, double-digit returns for stocks, with the Russell Growth Index dominating the Russell Value Index.

Over the next five years we expect reversals, resulting in:

  • Historically below-average, single-digit results for equities
  • Market leadership from profitable companies
  • Renewed success for disciplined active management approaches
  • Small-cap value reasserting its traditional leadership role

Royce Funds with Highest Average Annual Total Returns - Five Years Ended 9/30/15 (%)

U.S. Funds 3Q15* YTD* 1YR 5YR 10YR Gross
Operating
Expenses
Net
Operating
Expenses
Smaller-Companies Growth -11.0 -3.0 3.6 9.9 6.3 1.34 1.25
Micro-Cap Opportunity -19.8 -16.4 -13.9 9.4 N/A 1.56 1.28
Opportunity -15.5 -14.9 -9.7 9.1 6.1 1.15 1.15
Total Return -9.6 -8.9 -3.9 9.1 5.9 1.19 1.19
Special Equity** -11.3 -11.8 -4.2 8.7 7.4 1.12 1.12
Global/International Funds 3Q15* YTD* 1YR 5YR 10YR Gross
Operating
Expenses
Net
Operating
Expenses
Global Financial Services -10.2 -3.7 0.4 11.9 7.0 1.93 1.74
European Small-Cap -3.0 8.3 -0.5 4.3 N/A 2.98 1.29
International Small-Cap -9.3 -5.2 -11.2 1.6 N/A 5.38 1.29
Global Value -9.3 -2.3 -7.9 0.9 N/A 1.35 1.29
Indexes 3Q15* YTD* 1YR 5YR 10YR Gross
Operating
Expenses
Net
Operating
Expenses
Russell 2000 Index -11.9 -7.7 1.2 11.7 6.5 N/A N/A
Russell 2500 Financial Services Index -3.7 -0.7 8.7 13.0 5.2 N/A N/A
Russell Europe Small Cap Index -4.8 4.8 1.7 7.8 5.6 N/A N/A
Russell Global ex-U.S. Small Cap Index -11.2 -4.4 -8.6 3.0 4.6 N/A N/A
Russell Global Small Cap Index -11.6 -5.9 -4.9 6.0 5.1 N/A N/A

* Not Annualized
**Only available to existing investors and relationships

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, and reflects the reinvestment of distributions. Returns are those of the Funds’ Investment Class or Service Class if no Investment Class exists. Performance prior to the date of commencement of certain Funds’ Investment Class shares (Royce Smaller-Companies Growth Fund - 3/15/2007 and Royce Global Value Fund – 8/31/10) reflects Service Class results. Shares of a Fund's Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Fund’s Investment Class. Past performance is no guarantee of future results. Current performance may be higher or lower than performance quoted. Returns as of the most recent month-end may be obtained here. Investment return and principal value will fluctuate, so that shares may be worth more or less than their original cost when redeemed. For detailed information on the one-, five-, 10-year, and since inception performance as of quarter-end and for expense information for The Royce Funds, please see our Prices and Performance page.

Gross annual operating expenses reflect each Fund's gross total annual operating expenses and include management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Net annual operating expenses reflect contractual fee waivers and/or reimbursements. All expense information is reported as of the Fund's most current prospectus. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by any applicable Fund through its investments in mutual funds, hedge funds, private equity funds and other investment companies. Royce & Associates has contractually agreed, to waive fees and/or reimburse operating expenses, to the extent necessary to maintain the net annual operating expenses through April 30, 2016 (excluding brokerage commissions, taxes, interest, litigation expense, acquired fund fees and expenses and other expenses not borne in the ordinary course of business) through April 30, 2016 at or below each Fund’s Classes listed below is as follows: Royce Smaller Companies Growth Fund Investment Class at or below 1.24%, Royce Micro-Cap Opportunity Fund Investment Class at or below 1.24%, Royce Global Financial Services Fund Service Class at or below 1.49%, Royce European Small-Cap Fund Investment Class at or below 1.29%, Royce International Small-Cap Fund Investment Class at or below 1.29%, Royce Global Value Fund Investment Class at or below 1.29%.

Important Disclosure Information

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LLC, and, of course, there can be no assurances with respect to future small-cap market performance. All indexes referenced are unmanaged and capitalization-weighted. Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell© is a trademark of Russell Investment Group. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. The returns for the Russell 2500-Financial Sector represent those of the financial services companies within the Russell 2500 index. The Russell Global ex-U.S. Small Cap Index is an index of global small-cap stocks, excluding the United States. The Russell Global ex-U.S. Large Cap Index is an index of global large-cap stocks, excluding the United States. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The Nasdaq Composite is an index of the more than 3,000 common equities listed on the Nasdaq stock exchange. All index returns for the Russell Global ex-U.S. Small Cap and the Russell Global ex-U.S. Large Cap indexes include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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