article 06-30-2015

Royce Micro-Cap Opportunity Fund Manager Commentary

Our expectation 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.

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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.


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

Builders FirstSource 1.29
EarthLink Holdings 1.28
RTI International Metals 1.05
Cambrex Corporation 0.69
RF Micro Devices 0.59
1 Includes dividends

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

McClatchy Company (The) Cl. A -0.83
OraSure Technologies -0.75
Noranda Aluminum Holding
Corporation
-0.65
Zumiez -0.61
Amber Road -0.59
2 Net of dividends

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 (%)

  QTR* YTD* 1 YR 3 YR SINCE INCEPT. DATE
Micro-Cap Opportunity -0.75 4.30 -4.04 18.39 16.43 8/31/2010
Russell Microcap 2.80 6.03 8.21 19.25 19.07 N/A
Russell 2000 0.42 4.75 6.49 17.81 17.99 N/A
Annual Operating Expenses: Gross 1.56% Net 1.28%

* 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 1% 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. Gross operating expenses reflect the Fund’s total gross annual operating expenses and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Funds most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, (excluding dividend and interest expenses relating to short sale activities, 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 1.24% through April 30, 2016 and at or below 1.99% through April 30, 2025. 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. he Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund generally invests 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. (Please see "Primary Risks for Fund Investors" in the prospectus.) 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 Microcap Index includes 1000 of the smallest securities in the small-cap Russell 2000 Index. 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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