article 06-30-2015

Royce International Small-Cap Fund Manager Commentary

Our portfolio holdings emphasize our preference for high-quality, wealth-compounding businesses, particularly in sectors such as Industrials and Consumer Discretionary—two areas in which we were overweight versus the benchmark at the end of June.

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Fund Performance

Royce International Small-Cap Fund (formerly Royce International Smaller-Companies Fund) enjoyed a strong first half on an absolute basis even as it came up short on a relative scale. For the year-to-date period ended June 30, 2015, the Fund advanced 4.5% compared to a 7.7% increase for its benchmark, the Russell Global ex-U.S. Small Cap Index, for the same period. After a bearish finish to 2014, fortunes for many non-U.S. equity markets reversed in 2015's first quarter. During these volatile first three months, the Fund was unable to gain an advantage over its benchmark, falling 0.5% in the first quarter versus a 3.7% gain for the index.

The Fund found its footing in the second quarter, improving on both an absolute and relative basis. We were pleased to see International Small-Cap outperform the Russell Global ex-U.S. Small Cap in the bullish April and relatively more muted May. The Fund was even with the benchmark in the markedly bearish June, when markets were rocked largely by the Greek default and anxiety over China's plunging stock market. The Fund thus outpaced the index in the second quarter, climbing 5.0% compared to the non-U.S. smallcap index's 3.9% gain. The Fund outperformed the Russell Global ex-U.S. Small Cap for the since inception (6/30/08) period ended June 30, 2015.

What Worked... And What Didn't

Six of the Fund's eight equity sectors contributed to performance in the first half, with net gains from Financials making the largest positive impact, followed by Industrials and Health Care. When sector impacts are compared to the Fund's benchmark, only the first of the three made a positive impact. Based on country exposure, the top contributors were the U.K., Japan, and Hong Kong while the largest detractors from results were Brazil (by a wide margin), India, and Germany.

The portfolio's strength in the Financials sector came primarily from two of its top performers, each of which was a top-10 holding at the end of June. Value Partners Group is a Hong Kong-based firm that has focused on Asian markets for more than two decades. Its shares often closely parallel movements in the Hong Kong and Shanghai markets. Each climbed precipitously into May before cooling off with the bear market for Chinese stocks. Its value orientation having an understandable appeal to us, the company saw growth in its assets under management and improved performance and management fees, all of which helped its earnings. VZ Holding provides financial services to individual and corporate clients in Switzerland and Germany. The Swiss National Bank's surprise decision in mid-January to delink from the euro resulted in rapid appreciation for the Swiss franc, which in turn led VZ Holding's stock to decline as the Swiss market as a whole reacted negatively to the currency inflation. We took this opportunity to add shares, as we believe this is a high-quality company with a domestic business that has historically been largely unaffected by currency movements. When the company subsequently reported sterling 2014 results in March, its stock marched to new highs. Another top contributor and top-10 holding, e2v Technologies makes high-tech electronic components including radio frequency, microwave, and sensing components. While recent revenue growth was modest, the company continued to offer optimistic full-year guidance. Along with an earlier assurance that it planned on doubling EBIT by 2020, the news kept investors very interested in the stock through the end of June.

Industrials was a mixed bag on two levels—the sector did well in the portfolio but had a modest negative impact vis-à-vis the benchmark. In addition, while eight companies from the sector were among the Fund's top-20 contributors in the first half, it was also home to a pair of its largest detractors, including the top detractor for the first half, Brazil's Kepler Weber. The company manufactures food storage equipment including grain silos, conveyors, and animal feed mills. Ongoing weakness in the Brazilian economy, combined with a global commodity price decline, led to a sell off. Execution issues continued to hurt results for India's KPIT Technologies, which provides product engineering and application and consulting services to a number of industries. Its shares tanked after the company reported disappointing earnings for its fiscal fourth quarter as revenues fell and margins contracted. Seeing what we thought were better opportunities elsewhere, we exited both positions in April. One of 2014's top contributors, India's Shriram Transport Finance lends to the used truck market and was a significant detractor in the first half as it experienced a steep decline in profits based on increased costs associated with bad loans.


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

Value Partners Group 1.64
e2v technologies 0.61
VZ Holding 0.60
Blosensors International Group 0.47
Norbert Dentressangle 0.41
1 Includes dividends

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

Kepler Weber -0.48
KPIT Technologies -0.40
Shriram Transport Finance -0.36
Apollo Tyres -0.31
Zuiko Corporation -0.29
2 Net of dividends

Current Positioning and Outlook

Effective May 1, 2015, Dilip Badlani and Jim Harvey became the Fund's portfolio managers (Dilip having served previously as assistant portfolio manager since 2013). Mark Rayner continues to serve as assistant portfolio manager. Our portfolio holdings emphasize our preference for high-quality, wealth-compounding businesses, particularly in sectors such as Industrials and Consumer Discretionary—two areas in which we were overweight versus the benchmark at the end of June.

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

  QTR* YTD* 1 YR 3 YR 5 YR SINCE INCEPT. DATE
International Small-Cap 5.03 4.49 -9.11 7.66 6.94 5.00 6/30/2008
Russell Glo x US SC 3.93 7.74 -3.46 11.35 8.99 4.05 N/A
Annual Operating Expenses: Gross 1.84% Net 1.54%

* 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 2% 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 Service Class (its oldest class). Gross operating expenses reflect total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive its fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, (excluding brokerage commissions, taxes, interest litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.54% through April 30, 2016. 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 may invest a significant portion of its assets in foreign companies, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, currency or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) In addition, as of 6/30/15 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund’s overall value to decline to a greater degree. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" 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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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