article 12-31-2014

Royce Micro-Cap Fund Manager Commentary

Fund Performance

Royce Micro-Cap Fund lost 4.1% in 2014, trailing both its benchmark, the Russell Microcap Index, and the smallcap Russell 2000 Index, which rose 3.6% and 4.9%, respectively, for the same period. The Fund's participation in the more quietly bullish first half was more limited than we would prefer—the Fund was up 1.0% for the six-month period ended June 30, 2014—but things grew worse when a wave of volatility hit the small- and micro-cap markets in the year's second half. Share prices began to fall following a small-cap high on July 3. In the third-quarter downdraft, the Fund fell 10.0% compared to respective declines of 8.2% and 7.4% for the micro-cap and small-cap indexes. We were frustrated that the Fund was unable to hold its value more effectively in a down phase, which has been one of its historical strengths. the Fund's participation in the fourth-quarter rebound was again limited and contributed to its relative performance disadvantage in the calendar year. The Fund was up 5.5% in the fourth quarter versus 11.2% for the Russell Microcap and 9.7% for the Russell 2000.

An examination of longer-term periods showed more attractive results on both an absolute and relative basis. The Fund outperformed the micro-cap benchmark for the 10-year period ended December 31, 2014. (Data for the Russell Microcap only goes back to June 30, 2000.) the Fund also outpaced the Russell 2000 for the 15-, 20-year, and since inception (12/31/91) periods ended December 31, 2014. The Fund's average annual total return since inception was 11.9%. We remain proud of its long-term performance record.

What Worked... And What Didn't

Four of the Fund's 10 equity sectors ended the year in the red, with Energy posting the largest net losses followed by Materials. The negative impact of Industrials and Consumer Staples was far more modest. Energy holdings first gave then took away in 2014, going from the portfolio's top performer in the first half to its worst in the second. The reversal of fortune was keyed by the nearly 50% decline in oil prices during the second half. TGC Industries provides geophysical services to oil and gas companies, such as seismic data acquisition services and gravity data. Its business mirrors that of longtime the Fund holding Dawson Geophysical. In October the two firms announced plans to merge, which should provide wider geographical reach, a stronger balance sheet, and more efficient operations, all of which should prove useful while we wait for commodity prices to recover. Total Energy Services, which was the Fund's twentieth-largest holding at the end of 2014, is a Calgary-based service company that provides contract drilling, equipment rentals, and compression and processing work. Conservatively capitalized, it's a high-return business that we have long regarded as especially well-run. We trimmed our position in 2014. Like many of our energy services holdings, it continued to execute effectively through the painful industry cycle.

Outside of Energy, maternity apparel retailer Destination Maternity continued to labor through a challenging retail market. A new CEO was hired in August with plans to manage inventories more effectively, improve store layouts, and refresh merchandise, all of which inspired our confidence in a turnaround that will require additional patience. Both Olympic Steel and Universal Stainless & Alloy Products grappled with ongoing sluggishness for industrial metals. Companies in the steel business have had no pricing power due to utilization rates being less than optimal. As with Destination Maternity, the turnaround is taking more time than we had initially anticipated. We held shares of all of these stocks at the end of 2014.

VASCO Data Security International specializes in bank security and develops security systems to secure and manage access to user digital assets. Its stock made two significant upticks in the first half. In February, its shares rose on better-than-expected fourth quarter of 2013 earnings and a strong outlook for fiscal 2014. Increased revenues and ongoing earnings strength saw the shares getting another major boost late in April, especially with HSBC, USA, its customer, offering VASCO authentication solutions to its retail customers. In October, its stock climbed yet again after beating estimates for third-quarter revenue and earnings. We sold the last of our shares in December. We held a stake in San Jose-based Super Micro Computer, which provides specialized high performance server solutions. Its recent successful forays into cloud computing data storage helped its earnings to soar steadily in 2014.

Top Contributors to Performance
For 2014 (%)

VASCO Data Security International 0.87
Super Micro Computer 0.52
CRA International 0.46
Furiex Pharmaceuticals 0.42
Zumiez 0.41
1 Includes dividends

Top Detractors from Performance
For 2014 (%)

TGC Industries -0.67
Total Energy Services -0.65
Destination Maternity -0.49
Olympic Steel -0.47
Universal Stainless & Alloy Products -0.43
1 Net of dividends

Current Positioning and Outlook

Sector weightings at year end were relatively unchanged from where they stood at the end of 2013. We continue to emphasize more economically sensitive sectors, such as the Fund's three largest at the end of the period—Industrials, Information Technology, and Consumer Discretionary. Our view is that many portfolio holdings in these (and other) sectors should benefit from a faster-growing economy that also could reward disciplined approaches that focus on fundamentals. So while we were not pleased with the Fund's recent performances, we remain confident about its prospects going forward.

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

Micro-Cap 5.49 -4.13 7.89 7.50 6.78 10.11 10.95 11.89 12/31/1991
Russell Microcap 11.19 3.65 21.81 16.14 5.96 N/A N/A N/A N/A
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 9.63 9.86 N/A
Annual Operating Expenses: 1.56%

* 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 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, other expenses, and acquired fund fees and expenses. 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. Shares of the Fund’s Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class. 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 invests primarily in 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.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% 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 Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. 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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