article 06-30-2014

Royce Heritage Fund Manager Commentary

In 2013, Royce Heritage Fund did fine on an absolute basis but disappointed on a relative basis. During the first half of 2014, it did much the same, though it managed to slightly narrow the gap with its benchmark. The Fund rose 2.9% for the year-to-date period ended June 30, 2014, trailing its benchmark, the small-cap Russell 2000 Index, which gained 3.2% for the same period.

The first quarter, in which the Fund rose 0.5%, was positive for most equities. However, the pace of returns slowed considerably following the fast-paced bull run that lasted through most of 2013, particularly during its last seven months. A new Fed chair, miserable winter weather through much of the eastern part of the U.S., and ongoing concerns about the pace of economic growth all gave investors pause at one point or another in 2014’s opening months. There was not enough anxiety, however, to reverse the course of the upswing—it only caused the bull to slow his pace. Small-caps reached an interim high on March 4 and the ensuing correction lasted into mid-May before shares began to rally again. We were pleased that the Fund outpaced the Russell 2000 from this early March high through the end of June. (More market cycle results can be found here.)

The Fund climbed 2.4% compared to a 2.0% increase for the Russell 2000 for the second quarter. The market rewarded lower-quality companies in the first quarter and during the low-key rally that closed out the first half, while higher-quality companies (mostly in the form of profitability and/or high returns on invested capital) led during the short correction. We think investors are attempting to sort out both the present and future in an economic climate in which the Fed is gradually stepping back. To us, the economy looks poised for faster growth. We believe this should benefit disciplined active approaches such as our own that emphasize absolute returns and a long-term investment horizon.

We were pleased that the Fund stayed ahead of the Russell 2000 for longer-term periods. Heritage beat its benchmark for the 10-, 15-year, and since inception (12/27/95) periods ended June 30, 2014. The Fund’s average annual total return since inception was 13.8%, a longterm record in which we take great pride.

Effective May 1, 2014, the Fund may now invest in companies with market capitalizations up to $15 billion (up from $5 billion). This offers more potential exposure to the full range of mid-cap securities, an area of the market in which we have taken more interest over the last several years.

The precious metals mining industry suffered through a brutal 2013, with respective declines of 36% and 28% in silver and gold prices conspiring with rising operational costs to make things truly awful. Valuations for several companies dropped to levels comparable to or lower than those of the market bottom in early 2009. All of this made us very pleased to see the industry rebound strongly during the first half of 2014. Dividend-paying silver miner Pan American Silver was the standout in the group. This still short-term recovery—along with nicely positive results for chemical companies—helped to give Materials top honors among the portfolio’s sector performances in the first half of 2014. Financials, Information Technology, and Energy also posted notable net gains for the semiannual period. The topperforming industry groups were energy equipment & services and capital markets, two areas of near-perennial interest to us. Two companies with what we regard as distinct technological advantages were major contributors in the energy equipment & services group. Helmerich & Payne is a contract driller with a specialty in high-tech drilling rigs that were in increasingly high demand as drilling activity picked up. Pason Systems makes instrumentation systems for on-land and offshore rigs that relay data, which improves drilling efficiency. More drilling activity and improved daily rental rates for its rig connectivity and remote diagnostics products were keys to its first-half success, as was the favorable outlook based on its pipeline of new products. Asset manager AllianceBernstein Holding L.P., which saw improvements in both portfolio performance and assets under management, was the leader in capital markets.

UTi Worldwide is a global supply chain logistics services and solutions company. The firm suffered through a series of problems, including the violation of its debt covenants, which led to an expensive and dilutive recapitalization. We held our shares in the hopes of a rebound. We also made a modest trim to our stake in engineering and construction business KBR during the first quarter in the belief that the company can recover from cancellations and losses of projects as well as the pushed-out start dates for some of its LNG (liquefied natural gas) ventures. We sold our stake in cloud-based technology services and software business Support. com after management embarked on shifts in strategy which had us question our original investment thesis. We were content to hold shares of footwear retailer Wolverine World Wide as many retailers were faced with declining business owing to poor retail traffic that we deemed temporary in nature.

Top Contributors to Performance
Year-to-Date through 6/30/14

Helmerich & Payne 0.30
Pan American Silver 0.25
Pason Systems 0.24
Signet Jewelers 0.22
AllianceBernstein Holding L.P. 0.22
1 Includes dividends

Top Detractors from Performance
Year-to-Date through 6/30/14

UTi Worldwide -0.29
KBR -0.22 -0.19
Wolverine World Wide -0.18
Patriot Transportation Holding -0.16
1 Net of dividends

Average Annual Total Returns as of Quarter-End 6/30/14 (%)

Heritage 2.40 2.90 18.49 8.57 16.91 9.43 11.24 13.78 12/27/1995
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.01 8.91 N/A
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Annual Operating Expenses: 1.49%

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 year-to-date performance for 2014.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at June 30, 2014, 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 June 30, 2014 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 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 (measured at the time of investment), 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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