article 01-08-2016

A Market in Transition?

In the fourth quarter of this volatile year equities rebounded and the Fed (finally) raised interest rates, which we believe points to a market in transition.

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A Volatile and Divergent Year Points to a Market in Transition

In 4Q15...

  • The Fed (finally) raised interest rates - 25 basis points on 12/16
  • Equities rebounded following the bearish third quarter
  • Growth stocks regained their edge over value
  • Within small-cap, Health Care recovered while Information Technology and Telecommunication Services rebounded

In 2015...

  • Single-digit losses for a number of global and domestic indexes
  • Important exceptions to these mostly modest equity declines—positive results for U.S. large-caps, the Nasdaq Composite, international small-caps, and European issues (especially small-caps)
  • Widening credit spreads, a growing numbers of defaults, and additional signs of a potential credit crunch
  • Broadly divergent small-cap sector results, with strong returns for Health Care and pockets of Information Technology accompanied by losses for Energy, Materials, Industrials, and Consumer Discretionary

Market Comments

Stocks Were Volatile in Spite of Positive Returns
While the major domestic indexes rallied in the fourth quarter, the road was rocky. U.S. stocks showed mostly positive results in October and November followed by losses through December. Small-caps demonstrated resilience as the fourth quarter was the third time in the past four years that the Russell 2000 bounced back from a down quarter. Mounting uncertainty about the prospects for global growth was not enough to end the long bull market that began in March 2009.

Small-Cap Growth Overtook Value
After giving up leadership in the third quarter, the Russell 2000 Growth Index took back its edge by outpacing the Russell 2000 Value Index in 4Q15. The small-cap growth index was up 4.3% versus a gain of 2.9% for its small-cap value counterpart. However, from the 2015 high for small-cap non-earners on 7/17/15 through the end of 2015, value was well ahead, losing 8.0% compared to an 11.3% decline for small-cap growth. With small-cap growth outpacing value by an historically wide margin on a trailing 10-year basis, we think that leadership from value is the more likely relative performance pattern going forward.

10-Year Annualized Return Spread Between the Russell 2000 Value and Growth Indexes

10-Year Annualized Return Spread Between the Russell 2000 Value and Growth Indexes

Sector Overview—Health Care Recovers, Energy Stays Low
In the Russell 2000, the best-performing sectors for 4Q15 were Health Care, Information Technology, and Telecommunication Services. After correcting meaningfully in the third quarter, Health Care showed strength led by life sciences tools & services and pharmaceuticals. Acquisition targets among semiconductor companies and growth-oriented software stocks led Information Technology. Consumer Discretionary and Energy both struggled, defying the historical trend of low energy prices creating widespread demand for discretionary purchases. Retail stocks were particularly hurt.

4Q15's Best and Worst Performing Sectors of the Russell 2000
Best Performing Sectors Worst Performing Sectors
Sector 4Q15 Returns (%) Sector 4Q15 Returns (%)
Health Care 9.6 Energy -7.9
Information Technology 6.8 Consumer Discretionary -3.2
Telecommunication Services 6.3 Industrials 2.7

Market Capitalization Overview—Large Remains in Charge
Results for the major U.S. equity indexes were uniformly positive in 4Q15, with the strongest results coming mostly from large-cap stocks. Considering the wide-ranging anxiety about the state of economies and markets, this was less surprising than the strength of the returns themselves. The Russell 1000 led (as it did in 3Q15), followed by the Russell Microcap, Midcap, and 2000 Indexes. It should be noted that quarterly returns for the micro-, small-, and mid-cap indexes were tightly correlated.

Around the Globe—A Robust Quarter
Like their stateside cousins, most non-U.S. indexes enjoyed a strong though volatile 4Q15. Consistent with the first three quarters of the year, Europe was strong. However, the rebounds for Asia and other markets led to results with narrower spreads than we saw earlier in the year.

Creeping Credit Issues
While the Fed's 25 basis point rate increase was unquestionably modest—and leaves rates at absolutely low levels—the more important issues are creditworthiness and contracting access. Credit spreads continue to widen while the number of defaults keeps growing. Historically, credit crunches have been bad news for small-cap stocks, being both more fragile in general and more reliant on credit. However, they have also provided historical opportunities for conservatively capitalized, financially strong businesses to take market share from weakened competitors.

Domestic Indexes and International Indexes

2015 Leaders and Laggards
With a large number of both Technology and Health Care companies, the Nasdaq Composite led the major domestic indexes for the calendar year, followed by the large-cap S&P 500 and Russell 1000. Each of these indexes finished the year in the black while the Russell 2000, Microcap, and Midcap all ended 2015 in negative territory, albeit modestly so. Within small-cap, growth was ahead of value. Outside the U.S. in 2015, Europe led Asia by a substantial margin. The cap size roles were the reverse of those in the U.S., however, as European small-caps outperformed their larger siblings.

Longer-Term Perspective—Returns Moving Lower Toward More Historically Typical Levels
Three- and five-year returns remained higher than their long-term rolling averages but were down noticeably from where they were for the same periods through 6/30/15. Large-cap led for the three-and five-year periods ended 12/31/15, followed for both periods by the Russell Midcap, Russell Microcap, and Russell 2000. The Russell 2000 Growth outpaced the Russell 2000 Value for the three- and five-year periods ended 12/31/15.

Rolling 5-Year Russell 2000 Quarterly Returns

Outlook—How We Think the Next 5 Years Will Be Different from the Last 5

Lower returns—Long-term returns for the Russell 2000 have shifted from spectacular highs to levels more in line with historical averages. We believe returns for the next three-to-five years will be positive, but lower than average.

Small-Cap Value Leadership—The Russell 2000 Growth has been outpacing the Russell 2000 Value by spreads not seen since the late '90s—until the last six months of 2015. The fourth-quarter rebound for small-cap growth notwithstanding, we believe this shift will be lasting and expect small-cap value to outperform growth over the next three-to-five years.

Contracting Credit—Access to credit has been contracting in recent months. We anticipate that the credit markets will continue to be more selective, creating a potential advantage for companies with strong balance sheets over the next three-to-five years.

Earnings Matter—We see profitability and profit growth becoming increasingly important, making it difficult for unprofitable or money-losing small-caps to maintain leadership. Earnings growth, as opposed to P/E expansion, looks likely to drive market returns.

Royce Funds with Highest Average Annual Total Returns - 5 Years ended 12/31/15
U.S. Funds 4Q15* 1 YR 5 YR 10 YR Annual
Operating
Expenses(%)
Special Equity Multi-Cap 0.5 -13.4 9.2 N/A 0.97
Smaller-Companies Growth 1.4 -1.6 7.2 5.8 Gross: 1.34
Net: 1.25
Total Return 1.9 -7.2 7.0 5.9 1.19
Dividend Value 2.5 -5.5 6.4 7.3 1.29
Special Equity -0.6 -12.4 5.8 6.9 1.12
Global/International Funds 4Q15* 1 YR 5 YR 10 YR Annual
Operating
Expenses(%)
Global Financial Services -1.1 -4.7 8.4 6.1 Gross: 1.93
Net: 1.74
International Premier 8.6 16.4 5.5 N/A Gross: 2.93
Net: 1.19
European Small-Cap 4.3 13.0 2.8 N/A Gross: 2.57
Net: 1.19
International Micro-Cap 3.2 -1.0 0.5 N/A Gross: 3.47
Net: 1.65
International Small-Cap 3.7 -1.6 0.0 N/A Gross: 4.92
Net: 1.19
 
Russell 2000 3.6 -4.4 9.2 6.8 N/A
Russell 2500 Financial Services 3.8 3.1 11.7 5.2 N/A
Russell Europe Small Cap 4.4 9.4 6.7 5.8 N/A
Russell Global ex-U.S. Small Cap 5.1 0.5 1.9 4.4 N/A

* Not Annualized

Important Performance 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 Fund’s Investment Class shares (Royce Dividend Value Fund - 9/14/2007) 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 at www.roycefunds.com. Investment return and principal value will fluctuate, so that shares may be worth more or less than their original cost when redeemed.

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 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 International Premier Fund Investment Class at or below 1.29%, 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 Micro-Cap Fund Service Class at or below 1.64%, Royce International Small-Cap Fund Investment Class at or below 1.19%.

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 view our performance section.

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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