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.

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 (%)

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

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