article 12-31-2013

Royce Opportunity Select Fund Manager Commentary

In 2013, Royce Opportunity Select Fund continued to be a happy exception in a now three-year period of challenging times for active management in the small-cap space. The Fund gained 44.6% in 2013, outpacing its small-cap benchmark, the Russell 2000 Index, which was up 38.8% for the same period. Opportunity Select’s calendar-year result formed part of a longer-term trend of outstanding absolute and relative returns.

Small-caps made a fast start to the year, which marked the return to market leadership of more defensive sectors and high-yielding equities at the expense of cyclical areas across most asset classes. The Fund managed the transition well, though it lagged its benchmark, gaining 11.5% versus 12.4% for the small-cap index. This bull phase was in contrast to the second half of 2012, which saw much-improved results from higher-quality companies—that is, those with higher returns on invested capital. Yet the Fund managed very well in both market phases.

Volatility returned to the markets in the form of a bearish April that gave way to a bullish May, while June was already proving to be a volatile month when the Fed announced on the 19th that it would likely begin to taper its bond-buying program later this year. Along with a fast-rising rate on the 10-year Treasury, underwhelming news out of China, and growing unrest in the developing world, the global markets swooned, though most domestic indexes were recovering by the end of the month. The Fund fared well in this more uncertain environment, rising 5.7% for the second quarter, ahead of the Russell 2000’s 3.1% increase. The third quarter saw a resumption of the red-hot pace of the first. The Fed signaled that tapering would be very gradual and in any case would not be starting for a few months, and the U.S. economy continued to expand, although at a slower pace than most of us would prefer. In this more placid climate, Opportunity Select stayed ahead of the Russell 2000, gaining 11.5% in the third quarter while the small-cap index was up 10.2%. The market’s pace slowed a bit in the fourth quarter as more volatility arrived in December. The Fund maintained its edge, beating the Russell 2000 with a gain of 10.0% compared to 8.7% for the benchmark.

We were very pleased with the Fund’s sterling results over recent calendar year and market cycle periods on both an absolute and relative basis. The Fund outperformed the Russell 2000 for the one- and three-year/since inception (8/31/10) periods ended December 31, 2013. Opportunity Select’s average annual total return for the three-year/since inception period was 25.0%.

Information Technology led all sectors by a comfortable margin, though Financials also posted substantial net gains followed in turn by the Industrials and Consumer Discretionary areas. The strength of tech holdings was in part the result of the sector’s substantial overweight in the Fund throughout 2013. The portfolio holds several technology businesses that we think are just beginning to recover, though several in the semiconductor & semiconductor equipment industry enjoyed robust results in 2013. Two of the Fund’s top three net contributors came from this group, though the market’s interest in each company had more to do with their respective roles in the red-hot solar energy industry. We reduced our position in both stocks as their respective share prices moved past our sell targets. SunPower Corporation manufactures high-performance solar electric equipment. SunEdison produces electronic-grade polysilicon used for electronics, solar cells, and film devices while also developing solar power projects. In spite of fears that reduced government subsidies would derail growth, the demand for solar technology shows no signs of cooling off. Many lesser-quality players have either exited the business or lost market share. Technological efficiency has improved, which has helped bring down costs, while China in 2013 called for a five-fold increase in installed solar capacity.

Radian Group provides financial guarantee insurance. Its services allow people to buy homes more quickly (often with smaller down payments), protect lenders against loan default, and lower the costs of mortgage origination and servicing. The housing industry’s rebound, as well as a decline in the number of defaults, helped its business to grow. We took gains through much of the first half and began selling again in November. BofI Holdings saw its web-based
banking services in both the consumer and commercial markets in high demand. We liked its long-term prospects, but its soaring stock price convinced us to sell off our position. A volatile stock price allowed us to buy shares of Quiksilver in 2013 when its valuation was more to our liking. The company produces and distributes clothing and accessories under its own brand name as well as DC, Roxy, and Hawk Skateboarding. It has seen uneven revenue growth—down in the U.S., rising in developing markets—and is not yet profitable. It has made moves in that direction, however, and we like its prospects in a strengthening economy.

Weaker earnings hurt results for Walter Energy, which produces metallurgical coal. Prices fell in the wake of slack demand in China. We sold our shares when the company’s efforts to refinance its debt looked a bit murky. We also parted ways with dry shipping business Genco Shipping & Trading after its shares began to suffer in the wake of debt finance concerns.

Top Contributors to 2013 Performance

SunEdison 2.55%
Radian Group 1.98
SunPower Corporation 1.73
BofI Holding 1.69
Quiksilver 1.49
1 Includes dividends

Top Detractors from 2013 Performance1

Walter Energy -1.43%
Genco Shipping & Trading -0.81
Mindspeed Technologies -0.64
Molycorp -0.34
CIBER -0.32
1 Net of dividends

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

  QTR YTD 1YR 3YR Since
Opportunity Select 10.01 44.61 44.61 17.43 24.98 8/31/2010
Russell 2000 8.72 38.82 38.82 15.67 23.54 N/A

Annual Operating Expenses: Gross 2.67 Net 1.38%%

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 total gross annual operating expenses and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Funds most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, other than dividends on securities sold short, acquired fund fees and expenses, and interest expense on borrowing, at or below 1.24% through April 30, 2015 and at or below 1.99% through April 30, 2023. 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. he Fund invests primarily in small-cap and micro-cap companies, which may involve considerably more risk than investing in larger-cap stocks. The Fund also invests primarily in a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may sell securities short which involves selling a security it does not own in anticipation that the security's price will decline. Short sales present unlimited risk on an individual stock basis since the Fund may be required to buy the security sold short at a time when the security has appreciated in value. The Fund may invest up to 25% 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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