Fund Performance

While Royce Special Equity Multi-Cap Fund did well on an absolute basis in 2014, its relative results were slightly disappointing. The Fund gained 9.3% for the calendar year, underperforming its benchmark, the Russell 1000 Index, which advanced 13.2% for the same period. A relatively slow, though still bullish, start to 2014 saw Special Equity Multi-Cap lose some ground to its benchmark early in the year. In the first half, the Fund advanced 5.3% versus a 7.3% increase for the Russell 1000 when overall market leadership remained with lower-quality stocks. Large-cap performance was in general more consistent during these first six months and did not correct as smallcaps did from early March through mid-May.

Compared to their smaller siblings, which corrected between July 3 and October 13, large-cap companies were even more stable in the third quarter. For that period, Special Equity Multi-Cap posted a small loss, down 0.4%, while the Russell 1000 managed a slight gain, up 0.7%. Equities were more in line as the year approached its end. For large- and small-cap stocks alike, the fourth quarter was a more dynamic period, one in which both the Fund and its benchmark did well. RSM gained 4.2% in the last quarter of 2014 while the Russell 1000 climbed 4.9%. Keeping in mind our disciplined, scrutinous, and quality-centric approach, the Fund's calendar-year results were not surprising. Through much of the year the market continued to favor companies without earnings or dividends and with low returns on equity and high betas. These types of businesses simply do not meet our exacting selection standards. Although the Fund underperformed its benchmark for the three-year period ended December 31, 2014 (+18.5% versus +20.6%), we remained pleased with Special Equity Multi-Cap's longerterm results. The Fund was even with the Russell 1000 for the since inception (12/31/10) period ended December 31, 2014. Special Equity Multi-Cap's average annual total return since inception was 15.5%.

What Worked... And What Didn't

Only two of the Fund's equity sectors—Industrials and Energy— finished the year with net losses. Their negative impact was comparatively modest, however, especially compared to the outsized contribution that came from the Information Technology sector, which more than doubled the net gains from the Fund's secondbest- performing group, Consumer Discretionary. The Health Care sector also made a strong contribution to 2014's returns, and Financials posted a small net gain. Special Equity Multi-Cap's top three performing industries came from Information Technology—software companies, semiconductors & semiconductor equipment stocks, and technology hardware storage & peripherals. We had success with multiline retail, the home of Nordstrom, which was the portfolio's top performer and second-largest holding at the end of the year. The health care equipment & supplies and health care providers & services industries also made solid contributions. The latter was dominated by a terrific performance from diagnostic testing, information, and services company, Quest Diagnostics. Two technology businesses rounded out the list of top contributors, Microsoft Corporation and KLA-Tencor, which makes yield management and process monitoring systems for the semiconductor industry. Hurt by poor sales, office products retailer Staples was a large detractor through most of 2014, which influenced the decision to sell our shares during the third quarter.

Current Positioning and Outlook

Effective on August 1, 2014, the Fund is a "non-diversified" fund within the meaning of the Investment Company Act of 1940. This means that it may invest a larger percentage of its assets in a single issuer or in a smaller number of issuers than a "diversified" fund. As of December 31, 2014, the Fund held 25 equity positions.

The combination of slower growth in healthcare costs on top of lower energy prices is striking—a decade ago, energy and healthcare costs were consuming nearly all of the gains in consumer discretionary income. We believe it is possible, even likely, that profit margins will expand rather than contract, as most expect. We still believe that more merger and acquisition activity is ahead and that our portfolio should receive its share and then some in light of both our methodology and the attractiveness of the issues. The forces behind more M&A activity include record-low interest rates, little other cost cutting opportunities, many companies being over capitalized (some with sizeable cash balances), activist investing putting deals into play, and the fact that acquiring companies shares have been advancing immediately of late.

Market correlation continues to fall, which suggests that the value of stock picking will continue to increase in importance. Inflows into equities (beyond what has been seen recently from individual investors) will likely be funded by the well above historical allocations in bond funds. This could accelerate if yields rise and bond prices fall. The more concerned about the market one is, the more we think quality companies—those with high returns on equity, low debt, and stable earnings—make sense.

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.

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