article 12-31-2013

Royce Financial Services Fund Manager Commentary

Royce Financial Services Fund continued its run of strong absolute and relative results with a terrific showing in 2013. The Fund gained 42.0% in 2013, outpacing its benchmarks, the small-cap Russell 2000 Index, which rose 38.8%, and the Russell 2500 Financial Services Index, which advanced 30.4% for the same period. The first quarter was a mostly consistent bull phase, with domestic share prices showing strength across all asset classes in the form of double-digit returns for most major U.S. indexes. The Fund fully participated in the good times, rising 14.2% versus respective gains of 12.4% for the Russell 2000 and 14.0% for the financial services component of the Russell 2500. This marked the third consecutive quarter in which Financial Services achieved positive quarterly performance and beat both its benchmark and the financial services companies in the Russell 2500.

The second quarter saw the Fund go four-for-four. This was a far more volatile period than the year’s first quarter, somewhat similar to 2012’s second and fourth quarters. The period between the beginning of April and the end of June saw underwhelming economic news from China (along with credit issues and the threat of an overheated real estate market), fresh attempts at fiscal stimulus in Japan, unrest—and plunging markets—in Turkey and Brazil, a spike in the 10-year Treasury note between mid-May and mid-June, and word from the Federal Reserve that it would likely begin to taper the pace of its bond purchase program later in the year. All of this was enough to send financial markets into a brief frenzy of selling, especially outside the U.S. Indeed, the major domestic equity indexes stabilized and finished the quarter in the black. Financial Services wound up the second quarter with a gain of 4.1% compared to respective advances of 3.1% and 1.3% for the Russell 2000 and Russell 2500 Financial Services Index.

The third quarter saw a return to the red-hot pace of the first. The Fed signaled that tapering would occur gradually (it got off to a modest, barely noticeable start in December), while the U.S. economy continued to expand. In this more hospitable climate, the Fund slipped behind one index while staying well ahead of the other. The Fund increased 8.3% in the third quarter while the Russell 2000 was up 10.2% and the financial services component of the Russell 2500 gained 4.0%. The market’s pace slowed a bit in the fourth quarter as December saw more volatility. The Fund reasserted its advantage, its 10.3% increase beating both the Russell 2000 (+8.7%) and the Russell 2500 Financial Services Index (+8.6%). The Fund also outpaced the latter index for the three-, five-, and 10-year/since inception (12/31/03) periods ended December 31, 2013. Financial Services lagged the Russell 2000 for these periods, though not by much. Average annual total returns for the three-year (+15.0% versus +15.7%), five-year (+18.9% versus +20.1%), and 10-year/since inception (+9.0% versus +9.1%) periods were quite close. We have been pleased with the Fund’s performance and very happy that it marked its first full decade at the end of 2013.

The portfolio’s substantial overweight in capital markets was a net positive for the year. The industry was more than well represented among the Fund’s top contributors, where it accounted for three of the Fund’s five best performers, as well as eight of its top 10 and 13 of its top 20. The Fund’s top-two contributors for the year were holdovers from the first half. WisdomTree Investments is an asset management company that primarily sponsors ETFs (exchange traded funds). Robust inflows and strong product line growth helped to attract investors to its stock. With its price on the rise, we trimmed our position, though it was the Fund’s twenty-thirdlargest holding at the end of the year. New York City-based Apollo Global Management, the Fund’s fifteenth-largest position, offers alternative asset and other investment management services including private equity, credit, and real estate funds. We like its core business, dividend, solid earnings history, and positive cash flows and were content to hold our shares as its earnings remained solid.

Net losses at the position level were scant and modest. The Fund’s most significant detractor for the calendar year was Sprott, a Canadian investment management company with a history dating back to 1981. The firm saw its share price decline as assets and fees declined, in large part the result of its significant exposure to the precious metals mining and energy industries, both of which suffered through much of the year. The former industry was especially hard hit, unable to escape the negative impact on revenue and stock prices of the respective 36% and 28% drops in silver and gold prices. We more than quintupled our position in Sprott in 2013, confident that this well-managed firm with long-term asset management expertise, particularly in natural resources investments, can right the ship. It was the Fund’s largest holding at year-end. Similar issues plagued U.S. Global Investors, a boutique registered investment advisory firm specializing in natural resources and emerging markets, two poor-performing areas of the market in 2013. It reported a net loss in August for fiscal 2013 as assets and revenues declined. We increased our position more than four-fold in the calendar year while other investors were fleeing the stock. Our confidence was bolstered by management’s decisions to exit the money market fund business, streamline costs, and reposition their products and services to focus on what the firm does best. It was the Fund’s twenty-fourth largest holding at the end of December.

Top Contributors to 2013 Performance

WisdomTree Investments 2.46%
Apollo Global Management LLC Cl. A 2.08
Regional Management 1.39
Artisan Partners Asset Management 1.35
Towers Watson & Company Cl. A 1.31
1 Includes dividends

Top Detractors from 2013 Performance1

Sprott -0.73%
U.S. Global Investors Cl. A -0.17
Xoom Corporation -0.10
Novation Company -0.10
Citadel Capital -0.10
1 Net of dividends

Average Annual Total Returns as of Quarter-End 12/31/13 (%)

  QTR YTD 1YR 3YR 5YR 10YR Since
Financial Services 10.33 42.00 42.00 14.99 18.94 8.97 8.97 12/31/2003
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 9.07 N/A
Russell 2500 Fnl Svc 8.55 30.40 30.40 14.83 14.93 6.44 6.44 N/A

Annual Operating Expenses: Gross 1.96% Net 1.58%

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

Important Disclosure Information

All performance information in this Report reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Gross operating expenses reflect the Fund’s gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse expenses to the extent necessary to maintain the Fund’s net annual operating expenses, other than acquired fund fees and expenses, at or below 1.49% through April 30, 2014. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Regarding the two “Good Ideas” tables shown above, the sum of all contributors to, and all detractors from, performance for all securities in the portfolio would approximate the Fund’s performance for 2013.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2013, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds' portfolios and Royce's investment intentions with respect to those securities reflect Royce's opinions as of December 31, 2013 and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Royce-managed portfolio in the future.

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. The Fund invests primarily in equity securities in the financial services sector. The Fund is not a complete investment program. It is designed for long-term investors who can accept the risks of investing in a fund with common stock holdings primarily in smaller-cap financial services companies. Therefore, the Fund is subject to certain risks associated with the industry, including, among other things, changes in government regulations, interest rate levels, and general economic conditions. The Fund invests primarily in micro-cap, small-cap, and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. As of 12/31/13 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. The Fund may invest up to 35% of its net assets in foreign securities, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) 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 unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2500 index represents the smallest 2,500 companies in the Russell 3000 index. The returns for the Russell 2500—Financial Sector represent those of the financial services companies within the Russell 2500 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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