article 12-31-2013

Royce Select Fund II Manager Commentary

The calendar-year return for Royce Select Fund II tracked its long-only global benchmark much more closely than it did the long-only domestic small-cap index that we also use to compare its performance. Select II increased 23.5% in 2013. This result narrowly trailed the 24.8% calendar-year gain for its global benchmark, the Russell Global Small Cap Index, while considerably lagging the 38.8% advance of the Russell 2000 Index in 2013. The Fund’s expanding number of investments headquartered or trading outside the U.S. did not serve it well in 2013, but we believe that the Fund is well positioned for a more widespread economic recovery in the years to come. Since May 1, 2011, Select II has had the ability to invest at least 80% of its net assets in the stocks of U.S. and/or non-U.S. companies with market capitalizations up to $5 billion. At year-end, the Fund had close to 60% of its net assets invested in foreign stocks, with the bulk invested in companies headquartered in Japan, Canada, and Hong Kong. Given the Fund’s portfolio composition through much of the year, it was not surprising that its performance matched more closely with its global benchmark for most of the year.

The first quarter of 2013 was bullish, but it was again led by more defensive sectors and industries. Select II was up 5.9% in the first quarter, trailing both the Russell 2000, which climbed 12.4%, and the global small-cap index, which advanced 8.6%. The second quarter brought a wave of volatility, more uncertainty, and enough variation in sector, industry, and company results to rekindle our hopes that the long period of close correlation and higher returns for lower-quality businesses was drawing to a close. While the Fund fell further behind the Russell 2000 between the beginning of April and the end of June, it outpaced its smallcap global benchmark over the same period. For the second quarter, the Fund finished with a slight gain of 0.4% versus a 3.1% gain for the Russell 2000 and a loss of 1.7% for the Russell Global Small Cap Index. Much of the portfolio’s net losses in the second quarter came from holdings in the metals & mining group.

Resembling the dynamic first quarter, the third quarter saw a furious rally. For the quarter, the Fund matched the Russell 2000’s 10.2% advance but narrowly missed the Russell Global Small Cap’s 10.5% return. European stocks led in this period, followed by U.S. small-caps. The fourth quarter saw a more subdued pace, as well as a brief run of volatility in mid-December. Select II gained 5.4% in the year’s closing quarter versus the Russell 2000’s 8.7% increase and the Russell Global Small Cap’s 5.8% gain. The Fund outperformed the Russell Global Small Cap for the five-year and since inception (6/30/05) periods ended December 31, 2013 while narrowly trailing the Russell 2000 for the since inception period (+8.3% versus +8.7%).

Seven of the Fund’s nine sectors finished 2013 with net gains. Information Technology, the Fund’s second-largest sector at year-end, led by a wide margin, though Industrials, Consumer Discretionary, and Financials also turned in solid contributions. The Fund’s biggest net-gaining position was E-House China Holdings, a real estate services company based in Shanghai, China. Its shares soared in the second half of the year following Chinese President Xi Jinping’s announcement in September that the government was committed to fixing the country’s fundamental economic troubles. We reduced our position in 2013. Based in East Aurora, NY, Astronics Corporation makes advanced high-performance lighting, electrical power, and automated test systems for the global aerospace & defense industries. We began trimming our position in February after record first-quarter earnings helped its share price to soar. It followed those impressive results with another record quarter as well as some acquisitions later in the year that investors seemed to like. Its stock price rose more or less steadily through 2013. By November we had sold the last of our shares. Bankrate aggregates and distributes personal finance content on the Internet and owns several financial services websites and lead generation properties. Its stock price cruised upward due to improved EPS (earnings per share) and better-than-expected guidance. We sold our shares in July and October.

Daphne International Holdings is a Chinese footwear maker and retailer that sells Aerosole shoes in China. The overall slowdown in the Chinese economy has taken its toll on Daphne’s business as lower levels of consumer spending led to a decline in sales and revenues. We like its management and market position, both of which gave us the confidence to build our position significantly as its share price slipped. We also added shares of Acacia Research, a Newport, C.A.-based patent licensing company that has recently been embroiled in lawsuits with tech giant Microsoft. Two consecutive quarterly losses did little to attract investors in 2013. Three precious metals related holdings were carryovers from the “Good Ideas at the Time” list from the first half of 2013. These positions, like the industry as a whole, could not escape the negative impact on revenue and stock prices of the respective 36% and 28% drops in silver and gold prices in 2013. In July, we sold our shares of Hochschild Mining while also parting ways with the Market Vectors Junior Gold Miners ETF. We chose to add shares of Sprott, a Canadian investment management company that has been in business since 1981 and has expertise in natural resource and commodity-based investing. We felt confident that it could benefit from an eventual recovery in commodity prices.

Top Contributors to 2013 Performance

E-House China Holdings ADR 1.71%
Astronics Corporation 1.25
Bankrate 1.23
Amira Nature Foods 0.94
Sarin Technologies 0.94
1 Includes dividends

Top Detractors from 2013 Performance1

Daphne International Holdings -1.32%
Acacia Research -0.85
Hochschild Mining -0.81
Market Vectors Junior Gold Miners ETF -0.77
Sprott -0.46
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR Since
Select II 5.36 23.51 23.51 6.51 19.48 8.27 6/30/2005
Russell 2000 8.72 38.82 38.82 15.67 20.08 8.74 N/A
Russell Global SC 5.83 24.77 24.77 8.09 18.49 7.96 N/A

Annual Operating Expenses: Gross 3.08% Net 1.60%

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 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 2% 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. 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 Select Fund II 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. Gross operating expenses reflect the Fund’s total gross annual operating expenses and include management 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 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 of borrowing, at or below 1.49% through April 30, 2015 and at or below 1.99% through April 30, 2023. 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 may invest a significant portion of its assets in foreign companies, which 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 Foreign Securities" 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 also invests primarily in micro-cap, small-cap, and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. In addition, the Fund 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 any one 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.) 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 Global Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks. Index returns 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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