Fund Performance

Royce Pennsylvania Mutual Fund gained 0.1% for the year-to-date period ended June 30, 2015 versus a gain of 4.8% for its small-cap benchmark, the Russell 2000 Index, for the same period. The Fund began 2015 with a historically uncharacteristic underperformance during a bearish January, which helped to seal up a relative disadvantage for the first quarter (+1.2% versus +4.3%). The Fund then beat the small-cap index in the April downturn before trailing in May and June. The second-to-last day of June was particularly harrowing, as the Fund saw a quarterly gain morph into a loss. For the second quarter, Pennsylvania Mutual fell 1.1% compared to a 0.4% advance for the Russell 2000.

Recent relative performance challenges have served to mask somewhat the fact that the Fund's five-year average annual total return for the period ended June 30, 2015 was 13.4%, a mark that was higher than both its own and its benchmark's respective five-year historical rolling averages of 10.7% and 7.4%. This says something to us about the historically atypical market of the last five years. Still, we remain committed to our risk-conscious, fundamentally rooted approaches and remain confident about the Fund's long-term prospects. Pennsylvania Mutual outperformed the Russell 2000 for the 15-, 20-, 25-, 30-, and 35-year periods ended June 30, 2015. The Fund's average annual total return for the 40-year period—all under the management of Chuck Royce—was 13.8%.

What Worked... And What Didn't

The Fund was underweight Health Care at the end of June, though this sector was Pennsylvania Mutual's top performer in the first half. However, the portfolio's net gains were paltry compared to those for Health Care businesses in the Russell 2000, which were led by biotech stocks. Net contributions for Pennsylvania Mutual came instead from companies clustered mostly in two industry groups—health care providers & services and life sciences tools & services. Other sectors in the black at the end of June included Financials, Consumer Staples, and Consumer Discretionary. Although four sectors—Energy, Materials, Industrials, and Information Technology—posted net losses for the first half, only the first of these registered more than a modest decline. The Energy sector's largest detractor was Unit Corporation, which we have held in the portfolio for more than 10 years. Unit operates as a contract driller and exploration and production company, among other energy-related businesses. Last year's significant decline in commodity prices drove its share price down. While a nascent recovery for oil prices and its own ongoing effective operations were helping its shares to come back a bit earlier in 2015, a first-quarter loss announced in May brought its stock back down. We held a decent-sized position at the end of the first half.

The Fund's largest detractor was MBIA, which provides financial guarantee insurance to public finance markets in the U.S. and internationally. Its position as an insurer of municipal bonds issued by Puerto Rico led its shares to drop significantly in late June as the island commonwealth's precarious financial condition grew more troubling. We held a small position at the end of June. Top-10 position Genesco also detracted. The company is a specialty retailer that sells footwear, headwear, sports apparel, and accessories. While we like its core businesses, execution has been an issue of late, particularly the yet-to-materialize turnaround for Lids hat and Lids Locker Room shops, which exerted enough pressure on margins to help create an earnings miss announced late in May.

In contrast, two companies from the Financials sector made the largest positive contribution to first-half performance. Shares of Ohiobased investment management firm Diamond Hill Investment Group climbed over much of the last few years, boosted most recently by strong earnings and growing revenues. SEI Investments, the Fund's eleventh-largest holding at June 30, is another asset manager that also provides technology solutions. The firm enjoyed double-digit growth in assets under management and administration, the result of both capital market appreciation and new client wins. We have always liked asset management businesses and think that more widespread economic growth coupled with an expanding global need for expertise in wealth management bode well for the industry as a whole.

Current Positioning and Outlook

In the context of a small-cap market recently led by biotech stocks and at other times dominated by similarly fast-growing, non-earning companies, the Fund's results in the first half were not entirely surprising. Due to the considerable potential earnings power we believe many of our holdings in more cyclical, less defensive sectors possess, our primary focus remained with Industrials, Information Technology, Consumer Discretionary, Energy, and Materials. If the U.S. economy continues to accelerate—and we believe it will—the inherent operating leverage in these positions should propel earnings, especially in the event of increased CAPEX spending. And while the demand for profitable and fundamentally sound small-cap companies has not yet materialized to the degree that we had anticipated, we have seen signs of a shift—one that we expect will look more dramatic as the economy picks up its pace.

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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