article 12-31-2014

Royce Heritage Fund Manager Commentary

Fund Performance

Royce Heritage Fund fell 1.1% in 2014, significantly trailing the 4.9% advance for its small-cap benchmark, the Russell 2000 Index, for the same period. The first six months of 2014, in addition to being a lower-return up phase, saw the Fund stay closer to the small-cap index. For the year-to-date period ended June 30, 2014, Heritage increased 2.9% versus a 3.2% gain for the Russell 2000. The gap between the Fund and its benchmark in the second half of the year was primarily the result of poor performance for the former during the fourth quarter.

The down phase in the third quarter saw both the Fund and the index losing 7.4%. Most small-cap prices recovered later in the year. The fourth-quarter rally, however, was not nearly as bullish for Heritage as it was for its benchmark. The Fund gained 3.7% while the Russell 2000 rose 9.7%. Fourth-quarter results were frustrating as we saw outperformance from sectors of the market in which we typically do not participate. Longer-term results, however, were better on both an absolute and relative basis. We were pleased to see the Fund outpace its benchmark for the 10-, 15-year, and since inception (12/27/95) periods ended December 31, 2014. The Fund's average annual total return since inception was 13.2%, a long-term record in which we take great pride.

What Worked... And What Didn't

Six of the Fund's nine equity sectors made a net contribution to calendar-year results. Information Technology was the leader while Consumer Discretionary and Financials also posted solid results. The leading industry groups were capital markets stocks, IT services companies, distributors (from the Consumer Discretionary sector), and semiconductors & semiconductor equipment businesses. The third of these groups was home to Core-Mark Holding Company, a marketer and distributor of consumer goods to convenience stores, grocery stores, drug stores, and other retail centers. Improved second- and third-quarter earnings and an increased dividend offered investors a convenient reason to buy. We reduced our stake by taking gains at various times as the stock appreciated by some 60% during the year. The Fund's third-largest holding at the end of 2014, Rogers Corporation is a technology company that manufactures specialty materials and components, including printed circuit materials, high-performance foams, and power electronic solutions. Somewhat volatile into the third quarter, its stock price soared in October after it reported record quarterly revenues, which capped a seventh consecutive quarter of year-over-year revenue growth. We were pleased to see each of its three core businesses contributing to its growth as we were buyers of its shares throughout 2014.

Industrials, Heritage's largest sector and a significant overweight versus the Russell 2000 at year end, detracted most from calendaryear results. Of the 21 industry groups that suffered net losses in 2014, nine are slotted in that sector, with machinery stocks and construction & engineering companies registering the largest negative impact. Houston-based KBR came from the latter group. Its shares plummeted as the company contended with several troubles (some related to energy's woes), such as cancellations and losses of projects as well as the pushed-out start dates for some of its LNG (liquefied natural gas) ventures. We were encouraged by a restructuring plan unveiled later in the year by the company's CEO, which entailed streamlining operations and reducing overhead costs, refocusing on core areas of traditional strength, and exiting four non-core businesses that were more heavily fixed-price project oriented. We built our position as its price slipped.

When oil prices declined by 50% in the second half, it had a predictably depressing effect on energy and related stocks throughout the equity market. And some parts of the industry felt much of the brunt more immediately than others. This was the case with many offshore drillers because of the higher operating costs inherent in that business. Based in Switzerland, Transocean is the world's largest offshore driller. Its shares corrected significantly as pre-existing industry oversupply of ultra-deep water drilling was compounded by the severe commodity-price decline. Unit Corporation is a longtime Royce holding that has always been something of an anomaly in its business because the energy industry traditionally, if not rigidly, separates oil and gas producers from service providers.

Top Contributors to Performance
For 2014 (%)

Core-Mark Holding Company 0.47
Rogers Corporation 0.36
ePlus 0.27
Pan American Silver 0.26
Bed Bath & Beyond 0.25
1 Includes dividends

Top Detractors from Performance
For 2014 (%)

Transocean -0.71
Unit Corporation -0.41
KBR -0.36
Trican Well Service -0.32
Reliance Steel & Aluminum -0.29
1 Net of dividends

Current Positioning and Outlook

As the year came to an end, we attempted to take advantage by buying shares of companies that saw their valuations disconnect from fundamentals due to concerns over European growth and more general deflation in basic materials. Effective February 2, 2015, Steven McBoyle became the Fund's lead portfolio manager after serving as portfolio manager since 2012. Chuck Royce and James Harvey continue to serve as portfolio managers.

Average Annual Total Returns as of Quarter-End 12/31/14 (%)

Heritage 3.73 -1.14 12.50 10.48 7.96 9.50 13.15 12/27/1995
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 8.76 N/A
Annual Operating Expenses: 1.49%

* Not Annualized

Current month-end performance may be obtained at our Prices and Performance page.

Important Performance, Expense, and Disclosure Information

All performance information in this piece 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 30 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). 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 Heritage'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 "Top Contributors" and "Top Detractors" 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 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 December 31, 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 December 31, 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 stocks, 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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