article 06-30-2014

Royce Special Equity Fund Manager Commentary

First-half results for Royce Special Equity Fund were somewhat disappointing on a relative basis. The Fund was up 0.2% for the year-to-date period ended June 30, 2014 compared to a gain of 3.2% for its small-cap benchmark, the Russell 2000 Index, during the same period. In the context of a market in which many companies with no earnings, no dividend, and other lower-quality attributes continued to outperform, this was not entirely surprising.

The strength of low quality was particularly evident in the first quarter. Although equity performance was generally positive, returns were well off the pace established in 2013, especially in last year’s second half. The Fund, however, had little participation and was down in the first quarter, falling 0.8% versus a gain of 1.1% for the Russell 2000. Several specialty retailers headed up the list of detractors in the Consumer Discretionary sector. The sector’s negative effect on first-quarter returns was exacerbated by its significant overweight versus the Russell 2000. However, as the economy continues to improve (as we believe it will), this will change, perhaps dramatically. The outlook for consumer spending looks healthy as a result of tame inflation, still restrained mortgage rates, rising household net worth, repaired household balance sheets, and improved consumer confidence. In addition, capacity utilization in the U.S. is inching towards the 80% rate; at this level we should start to see more hires and capital expenditures, reigniting the economy.

The second quarter was going well for Special Equity until June. The Fund outperformed during the April decline and the modest gain in May and posted better relative performance than its benchmark from the 2014 small-cap high on March 4 through the end of June. The Fund did lose ground, however, when the small-cap index gained 5.3% in June. As is often typical of that kind of move, it favored stocks without earnings or dividends, low returns on equity, and high betas. For the second quarter the Fund advanced 0.9%. Special Equity outperformed its benchmark for the 15-year and since inception (5/1/98) periods ended June 30, 2014. The Fund’s average annual total return since inception was 10.0%.

Numerous concerns began to register in the first quarter: the change in leadership at the Federal Reserve, the implications this change will have on the central bank’s policies, China’s shadow banking system, and harsh weather in much of the U.S. On March 19, 2014, Janet Yellen, the then-new Chair of the Board of Governors of the Federal Reserve System, mentioned that interest rates could rise “in six months or so” following the end of quantitative easing. Was it intentional to release this negative assessment at that time to get it out of the way? Yellen significantly reduced uncertainties (intentionally or not) when she mentioned this “six months or so” time frame. Investors have now passed three consecutive psychological hurdles: Fed tapering, the end of QE3 (the third round of quantitative easing), and the time frame of rate hikes. We think this good news can continue to lift equities.

Consumer Discretionary stocks remained the portfolio’s most significant detractors for the entire first half, its largest net losses coming from specialty retail. In fact, the sector’s losses as a whole were mitigated by revved-up results for the Fund’s top-performing industry, auto components. Bed, Bath & Beyond led all of the Fund’s detractors. We increased our position in this New Jersey-based retailer of a wide variety of domestic merchandise. It was The Fund's fifth-largest holding at the end of June. We added shares of top-10 position Children’s Place, another NJ-based retailer, which sells children’s specialty apparel throughout North America. Another top-10 holding, Schweitzer-Maudit International, runs a global business from Georgia manufacturing paper and reconstituted tobacco products for the tobacco industry. We increased our stake during the first half.

Industrials contributed most to first-half gains, led by solid results from the electrical equipment and machinery industries. The best-performing stock in the first half was Standard Motor Products, the Fund's tenth-largest position at the end of June. The Queens, New York-based company manufactures and distributes replacement parts for motor vehicles in the automotive aftermarket industry and operates in two segments, engine management and temperature control.

Treasury rates have not risen as of yet. This is an interesting point, as it suggests that rising rates, due to stronger economic activity, will not weigh down the market. We believe we are close to a move towards greater cyclical exposure in the marketplace. We think that investors will increasingly abandon their obsession with counter-cyclicals and start to embrace anything with economic leverage in the U.S. An economic outcome that we increasingly believe in resembles Bill Gross’s “new neutral:” Slower but more consistent growth than we have seen in the past with resulting lower-than-expected inflation and interest rates. This is a variation of the “Goldilocks” outcome—not too hot or too cold. If this is indeed the case, we believe P/E multiples will likely stay at current levels and possibly even increase.

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

Standard Motor Products 0.58
Minerals Technologies 0.46
Teradyne 0.41
Hubbell Cl. B 0.34
Finish Line (The) Cl. A 0.30
1 Includes dividends

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

Bed Bath & Beyond -1.38
Schweitzer-Mauduit International -0.52
Children's Place Retail Stores -0.45
Buckle (The) -0.34
Weis Markets -0.23
1 Net of dividends

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

Special Equity 0.93 0.16 15.27 13.21 16.16 8.61 11.23 10.03 5/1/1998
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.01 7.13 N/A
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Annual Operating Expenses: 1.13%

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 Investment Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees and other expenses. Shares of RSE’s Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class. 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 invests primarily in small-cap and micro-cap stocks which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) As of 6/30/14, 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. 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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