Fund Performance

Non-U.S. small-cap indexes trailed their domestic peers once again in 2014, and Royce International Smaller-Companies Fund was unable to resist the trend. The Fund was down 7.3% in 2014 while its benchmark, the Russell Global ex-U.S. Small Cap Index, lost 3.6% for the same period. Although the Fund also trailed its benchmark in the first half of 2014, its results were both nicely positive and strong on an absolute basis. For the year-to-date period ended June 30, 2014, International Smaller-Cos advanced 6.6% versus 7.5% for the non- U.S. small-cap index.

The Fund's fortunes began to change when a downdraft hit smallcaps across the globe. International Smaller-Cos fell 7.0% in the third quarter while the Russell Global ex-U.S. Small Cap declined 6.2%. All of the Fund's nine equity sectors detracted from performance in the quarter, with Health Care, Industrials, and Materials registering the largest negative impact. At the country level, companies headquartered in France, the United Kingdom, and Japan were the biggest detractors in aggregate from third-quarter performance.

While U.S. small-caps rallied in the fourth quarter, elsewhere in the world smaller companies in general managed only to lose less than they had in the third quarter. International Smaller-Cos was down 6.4% in the final quarter of 2014 compared to a 4.5% loss for the benchmark. Holdings in the U.K. and Japan were once again significant detractors, as were positions headquartered in Malaysia and Brazil. We remain disappointed with the Fund's intermediate and long-term relative results. International Smaller-Cos outperformed the Russell Global ex-U.S. Small Cap for the since inception (6/30/08) period ended December 31, 2014.

What Worked... And What Didn't

For the calendar year, all but one of the Fund's eight equity sectors were in the red. Consumer Discretionary made the largest negative impact by a good-sized margin, with Energy and Materials also posting sizable net losses. Industrials was the Fund's only sector to post net gains, in part due to the strong showing for the machinery industry. At the country level, India was the top contributor to returns for the year (as was the case in the semiannual period, when in May probusiness Bharatiya Janata Party candidate Narenda Modi was elected Prime Minister by a landslide victory). In fact, four of the Fund's top-five contributors to 2014 performance were Indian companies, two of them machinery stocks. AIA Engineering manufactures chromium grinding balls used by the mining and cement industries. In May the firm reported an increase in after-tax profit year-over-year for its fiscal fourth quarter, leading us to take more gains as its stock advanced. A strong balance sheet and rising profits initially drew us to rolling-bearings manufacturer FAG Bearings India. We sold our shares between May and August as its stock price began to reach our sell target. Shriram Transport Finance is India's leading lender to the used truck market and another beneficiary of the country's improved business conditions. We took gains as its shares rose. Magellan Aerospace is an Ontario-based company that serves the civil aerospace and defense markets. Its shares benefited from a strong aerospace and defense capital spending cycle as well as weakness in the Canadian dollar, which significantly increased its competitiveness versus U.S. suppliers. We trimmed our stake in December, though it was a top- 15 holding at the end of 2014.

Globaltrans Investment GDR endured a difficult year, seeing further share price declines in the second half. The company is a leading private freight rail transportation group operating in Russia, the CIS (the Commonwealth of Independent States, including Ukraine), and the Baltics. Globaltrans lost about 70% of its value by year end, hurt by tensions in Ukraine and the weakening ruble. With more than 85% of freight transported by rail in Russia, we believe the company can improve its competitive position in the next couple of years. We like its corporate governance and constructive attitude towards capital allocation. EnQuest is a London-based oil and gas development and production company. A nearly 50% decline in oil prices in the second half keyed the company's plummeting share price. Brasil Brokers Participacoes is one of Brazil's two leading real estate brokerages. A weak real estate market and low consumer sentiment contributed to the company's fading share price, which was also hampered by political uncertainty through the first nine months of the year. As we anticipated, the re-election of president Dilma Rousseff has not yet led to a more business-friendly environment in Brazil. We sold some shares in October and December. The strength of the U.S. dollar also played a role in the performance of non-U.S. holdings.

Current Positioning and Outlook

Though out of favor at the end of 2014, we continue to believe that the international small-cap market is home to many high-quality companies. We see the most potential for growth in developed nations such as Japan, the U.K., and France as well as in certain emerging markets such as India and Brazil. Our focus remains on some of the more economically sensitive areas of the market, such as Industrials and Consumer Discretionary, though International Smaller-Cos was also overweight in Health Care at year end. We have been populating the portfolio with companies that we believe can remain competitive in a highly challenging environment for non-U.S. small-cap stocks.

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

* Not Annualized

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

Important Performance, Expense, and Disclosure Information