Fund Performance

Royce Micro-Cap Opportunity Fund (formerly Royce Opportunity Select Fund) gained 4.3% for the year-to-date period ended June 30, 2015, trailing both its new benchmark, the Russell Microcap Index, which rose 6.0%, and its former yardstick, the small-cap Russell 2000 Index, which was up 4.8% for the same period. (We are using the Russell Microcap as the Fund's new benchmark because it better reflects the Fund's selection universe, part of changes that became effective on May 1, 2015.) Through much of the first half—as late as early June, in fact—Micro-Cap Opportunity led both indexes. While it began to cede a bit of ground as June rolled on, it took only one very volatile day—June 29 to be exact—for the Fund to slip well behind the indexes in the first half.

We were otherwise pleased with first-half results. Although stocks endured a downturn in January, Micro-Cap Opportunity climbed 5.1% in the first quarter versus respective gains of 3.1% and 4.3% for the Russell Microcap and Russell 2000. The second quarter began in a similarly bearish fashion, though losses were generally less severe in April than earlier in the year. For the second quarter the Fund lost 0.7% versus a gain of 2.8% for the Russell Microcap and 0.4% for the Russell 2000. Micro-Cap Opportunity Fund's average annual total return since inception was 16.4%.

The Fund's name change became effective on May 1, 2015 when it also began to operate under a new non-fundamental investment policy requiring 80% of its assets to be invested in stocks with market caps up to $1 billion. The Fund is being run closely to the way in which it has been since its inception, investing primarily in a limited number (generally less than 100) of mostly micro-cap stocks.

What Worked... And What Didn't

Five of the portfolio's nine equity sectors posted net losses in the first half, though for three—Financials, Energy, and Consumer Discretionary—the declines were modest and for the remaining two they were even smaller. One of these was Health Care, which made an outsized contribution to performance for both the Russell Microcap and Russell 2000. The sector was led by red-hot biotech stocks, and the Fund's significant underweight in both the sector and that industry loomed large in its first-half underperformance. The portfolio's largest detractor at the position level was The McClatchy Company, which publishes newspapers and provides original media content to digital sources. Its shares grew appreciably cheaper (and more attractive to us) during the first half as the firm continued to adjust to the radically altered media landscape, which has not been kind to newsprint. However, with approximately two-thirds of its revenue now coming from non-print sources, we think the company is responding effectively to new media realities. We added shares in the first quarter. We also built our position in OraSure Technologies as its stock stumbled. The company develops saliva-based diseasetesting products, many for more sensitive healthcare situations. Its stock was up in 2014 on news of new product releases. We suspect that expectations may have raced ahead of reality, which resulted in nervous investors when OraSure then reported a fourth-quarter loss in February, even though the loss was lower than had been estimated. We like its niche and its revenue growth potential.

Information Technology easily led all of the Fund's sector groups, with net gains nearly triple those posted by Industrials, the second-best performing sector in the first half. Four of its industry groups made particularly notable contributions—semiconductors & semiconductor equipment, internet software & services, communications equipment, and software. One of the Fund's top contributors was EarthLink Holdings, which has made the transition from being a general internet services provider to more businessoriented managed services. We initially viewed it as an asset play and liked its new management's plans to better focus the business and their ability to cut costs in a flat-growth environment. The company's steady progress toward profitability attracted more investors, though we believe it still has room to grow and held a large position at the end of June.

Top contributor Builders FirstSource, which makes building products for residential construction, saw its shares hit the roof when it announced the acquisition of a competitor in mid-April. RTI International Metals benefited from a similar condition for micro-cap companies—its profitability in producing titanium for the aerospace industry drew the interest of a larger firm in the same business. Alcoa announced an agreement to buy the company in March, prompting us to sell our position.

Current Positioning and Outlook

Our overall outlook is very positive. We think the market has had the time it needed to fully digest the first quarter's slowdown in economic growth and the likelihood of increased interest rates in the short run. Our expectation, then, is that the economy will keep growing, which should help a number of micro-cap companies, especially those that have been flat or down over the last couple of years. In particular we believe that we will see more robust earnings recovery in 2016. At the end June the portfolio held large overweights in Information Technology, Consumer Discretionary, and Materials while also being underweight in Industrials.

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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