article 06-30-2015

Royce Capital FundMicro-Cap Portfolio Manager Commentary

We maintain the belief that many portfolio holdings in economically sensitive (and other) sectors should benefit from a faster-growing economy that also could reward disciplined approaches that focus on fundamentals.

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Fund Performance

Royce Capital Fund–Micro-Cap Portfolio fell 1.1% for the year-to-date period ended June 30, 2015, lagging both its benchmark, the Russell Microcap Index, and the small-cap Russell 2000 Index, which advanced 6.0% and 4.8%, respectively, for the same period. The Fund was again challenged by its lack of participation in a bullish period for both micro-cap and small-cap stocks. However, it should be noted that returns within each asset class were narrower than the pleasing year-to-date results for the respective indexes might suggest, with biotech remaining a primary driver of returns during the first half of 2015.

In the first quarter, Royce Micro-Cap Portfolio fell 0.2%, a disappointing result that was mostly due to a dismal and bearish January. Positive returns for the Fund in both February and March could not push the portfolio into the black for the quarter. By contrast, the Russell Microcap gained 3.1% for the first quarter while the Russell 2000 rose 4.3% for that same period. The Fund's performance worsened in the second quarter, especially hurt by the wave of volatility that the Greek default sent through the markets at the end of June. The Fund lost 0.9% for the second quarter while the micro-cap index and small-cap index increased 2.8% and 0.4%, respectively. Longer-term relative results were better. Royce Micro-Cap Portfolio outperformed the Russell Microcap for the 15-year period ended June 30, 2015 and beat the Russell 2000 for the 15-year and since inception (12/27/96) periods ended June 30, 2015. (Data for the Russell Microcap only goes back to June 30, 2000.) The Fund's average annual total return since inception was 10.7%. We are very proud of the Fund's long-term performance history.

What Worked... And What Didn't

Health Care was something of a double-edged sword for the portfolio. The sector comfortably led both the Fund and the Russell Microcap in the first half. Returns for the index, however, were dominated by stratospheric results for biotech stocks as well as hearty returns for pharmaceuticals companies. Most of these businesses lack either the conservative capitalization or earnings profile that we look for when building our portfolio. The Fund was therefore significantly underweight in Health Care during the first half and had little exposure to biotech and pharmaceuticals. Net gains came primarily from companies in the health care equipment & supplies and the health care providers & services industries. So while the sector was by far the portfolio's top contributor in the first half, its net gains were not as vigorous as were those for the sector within the Russell Microcap.

Firearms maker Smith & Wesson Holding Corporation was the Fund's best-performing position in the first half. The company continued to gain market share while recent sizable investments in R&D have been driving significant product innovation. Its shares also benefited from effective cash flow allocation into strategic acquisitions that are providing vertical manufacturing integration as well as adjacent product offerings. The stock of financial services business INTL FCStone began to climb in February. It has a growing niche in automated international currency settlements and was thus rewarded in an increasingly volatile global currency market.

Of the Fund's five sectors that finished the semiannual period in the red, only Energy and Materials posted sizable net losses. Gulf Island Fabrication fabricates offshore drilling and production platforms, as well as other steel structures for the oil and gas and marine industries. Recent results have been hurt by the decline in commodity prices, which has led to a slowdown in its business. Still, we like how this low-debt, asset-strong firm has been executing through a highly challenging phase for its industry. We held a good-sized position at the end of June. Exposure to the energy industry also played a role in poor results for Global Power Equipment Group, which makes gas turbine generation equipment. Other factors contributing to the decline in its stock price were the resignation of its CEO in March and the announcement in May that it would need to restate financial statements. While this was a clearly disappointing turn of events, we chose to hold our position, at least for the short term. The company's highly attractive valuation and strong balance sheet offered enough interest for us to allow the dust to settle around a business that we like for the long-term. Two for-profit education businesses were also among the portfolio's top detractors in the first half—American Public Education and Capella Education. The industry has been under fire of late and is enduring a round of new, more stringent federal regulations. We think each of these companies has the management talent and fundamental strength to survive these challenges.


Top Contributors to Performance
Year-to-Date Through 6/30/15 (%)1

Smith & Wesson Holding Corporation 0.54
INTL FCStone 0.45
LSI Industries 0.38
Culp 0.32
Ennis 0.29
1 Includes dividends

Top Detractors from Performance
Year-to-Date Through 6/30/15 (%)2

Gulf Island Fabrication -0.54
American Public Education -0.34
Capella Education -0.33
Global Power Equipment Group -0.33
Graham Corporation

-0.29

2 Net of dividends

Current Positioning and Outlook

Sector weightings at the end of June were relatively unchanged from where they have stood over the last 18-24 months. This is due to our ongoing preference for more economically sensitive sectors, such as the Fund's three largest at the end of the period—Industrials, Information Technology, and Consumer Discretionary. We maintain the belief 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 the Fund's recent performances have fallen below our expectations, we remain confident about its prospects going forward. We are also pleased to announce that on May 1, 2015, Royce veteran Jim Stoeffel joined Jenifer Taylor as the Fund's co-portfolio manager. Jen has been involved in the Fund's management for more than 12 years while Jim joined Royce in 2007 as a portfolio manager.

Average Annual Total Returns as of Quarter-End 6/30/15 (%)

QTR* YTD* 1 YR 3 YR 5 YR 10 YR 15 YR SINCE INCEPT. DATE
Capital Micro-Cap -0.88 -1.06 -5.55 6.65 7.61 6.30 9.35 10.72 12/27/96
Russell Microcap 2.80 6.03 8.21 19.25 17.48 7.07 7.79 N/A N/A
Russell 2000 0.42 4.75 6.49 17.81 17.08 8.40 7.50 8.40 N/A
Annual Operating Expenses: 1.31%

* 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. Current performance may be higher or lower than performance quoted. The Fund’s total returns do not reflect any deduction for charges or expenses of the variable contracts investing in the Fund. Returns as of the most recent month-end may be obtained here. All performance and risk information reflects the result of the Investment Class (its oldest class). Shares of RCM’s Service Class bear an annual distribution expense that is not borne by the Investment 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. 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 year-to-date performance for 2015.

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, 2015, 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, 2015 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 investments in securities of larger-cap companies. (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 2000 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 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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