article 12-31-2013

Royce Heritage Fund Manager Commentary

While it might be hard to tell by looking only at its calendar-year return, we were not entirely pleased with the 2013 performance of Royce Heritage Fund, which turned in a fine performance on an absolute level but came well short of its small-cap benchmark. The Fund rose 26.0% in 2013, lagging its benchmark, the Russell 2000 Index, which increased 38.8% for the same period.

Heritage trailed in each of the year's four quarters, with its relative disadvantage consistent through most of 2013. So while the Fund took part in the primarily bullish market, its participation was limited. Considering our disciplined value approach this was not a disappointment in itself. The highly bullish first quarter saw many cyclical stocks fall behind more defensive areas after leading through the second half of 2012, when the Fund handily beat the Russell 2000 (+11.6% versus +7.2%). The Fund was up 9.2% in the first quarter compared to a 12.4% increase for the small-cap index. Volatility returned to the markets in the second quarter, starting with a bearish April. Negative macro news kept share prices moving in contrasting directions through much of the quarter. Challenges for China, unrest in developing nations such as Turkey and Brazil, a sharp rise in the 10-year Treasury rate during May and June, and word from the Fed that it would slow the pace of bond purchases at the end of 2013 all worried investors, primarily in April and June. However, unlike in 2011 and 2012, the domestic equity markets ultimately handled this news well in 2013. For the second quarter, Heritage gained 0.2% while the Russell 2000 rose 3.1%.

Perhaps the most convincing sign that investors were able to shrug off potentially disturbing macro developments was the generally strong showing for stocks in the third quarter, a period in which the Fund gained 8.4% compared to a 10.2% increase for its benchmark. The fourth quarter was not quite as robust—December proving somewhat volatile—but returns were solidly positive. Heritage was up 6.2% in the year's last three months compared to 8.7% for the Russell 2000. As highly risk-conscious managers, we were often frustrated navigating a market that exhibited only one direction—2013 being largely free of corrections—and showed the most favor to companies that we would deem low quality as so many small-cap performance leaders had high leverage, low ROIC (return on invested capital) and low rates of profitability. We were therefore not entirely surprised to have underperformed for the period.

Relative results improved over longer time spans. (Market cycle results can be found here.) The Fund outpaced its benchmark for the five-, 10-, 15-year, and since inception (12/27/95) periods ended December 31, 2013. Heritage's average annual total return since inception was 14.0%, a long-term record in which we take considerable pride.

The precious metals mining industry endured a miserable 2013, with respective silver and gold price declines of 36% and 28% in 2013 combining with rising operational costs to create an inhospitable environment. Valuations for several companies dropped to levels comparable to or lower than those of the market bottom in early 2009, which meant that, for now, the Fund has paid a hefty price for this exposure. Of the positions that detracted most from performance for the period, four of the top five, seven of the top 10, and 10 of the top 20 came from the metals & mining industry; all but two were involved in precious metals mining. Our view of the fundamentals and/or long-term prospects for individual businesses guided our actions through these difficult days. We sold our positions in Hochschild Mining, Allied Nevada Gold, and Gold Fields while we built positions Randgold Resources and Pan American Silver, confident that the latter two could eventually turn around.

Elsewhere in the portfolio, the news was mostly positive. Eight of the Fund's 11 equity sectors posted net gains for the period, led by Industrials and Financials. More-than-respectable net gains also came from the Information Technology and Consumer Discretionary sectors. Interestingly, each of the Fund's top contributors through the end of June made the same list for the full year, though in a slightly altered order.

The Fund's top contributor for the year was WisdomTree Investments, an asset management company that primarily sponsors exchange traded funds. Robust inflows and strong product line growth drove results. We sold our shares at rising prices between January and September. Although we still like its business, we also parted ways with Towers Watson & Company. The company offers human resource and financial consulting services and also manages employee benefit programs. One key to its strong year was its launch of One Exchange, the industry's first health benefits solution that leverages private and public health insurance exchanges. Top-ten position Manpower Group runs a global business providing employment services that include temporary staffing services, contract services, and training and testing of temporary and permanent workers. It benefited from the ongoing shift from permanent to temporary labor in certain countries and a slow recovery in France, its largest market. We were also intrigued by Manpower's decision to collapse what were effectively two business models (centralized infrastructure and local branch infrastructure) into one as a significant reset to the company's overall profitability.

Top Contributors to 2013 Performance

WisdomTree Investments 0.98
ManpowerGroup 0.97
Towers Watson & Company Cl. A 0.89
KKR & Co. L.P. 0.73
TD Ameritrade Holding Corporation 0.58
1 Includes dividends

Top Detractors from 2013 Performance1

Hochschild Mining -0.56%
Allied Nevada Gold -0.49
Gold Fields ADR -0.48
Randgold Resources ADR -0.40
Acacia Research -0.32
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR Since
Heritage 6.21 25.99 25.99 9.30 20.38 10.10 12.16 14.00 12/27/1995
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 8.97 N/A

Annual Operating Expenses: 1.51%

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. All performance and risk information reflects results of the Service Class (its oldest class). Price and total return information is based on net asset values calculated for shareholder transactions. Certain immaterial adjustments were made to the net assets of Royce Heritage Fund at 12/30/11 for financial reporting purposes, and as a result the net asset values for shareholder transactions on that date and the calendar year total returns based on those net asset values differ from the adjusted net asset values and calendar year total returns reported in the Financial Highlights. Operating expenses reflect the Fund’s total annual operating expenses for the Service Class as of the Fund’s most current prospectus and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Shares of RHF’s Consultant and R Classes bear an annual distribution expense that is higher than that of the Service Class. 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 generally invests a significant portion of its assets in micro-cap, small-cap, and mid-cap companies, 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. 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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