Fund Performance

Royce Special Equity Fund was down 0.5% for the year-to-date period ended June 30, 2015 versus a 4.8% gain for its small-cap benchmark, the Russell 2000 Index, for the same period. Most stocks staggered into the new year, losing value in January before recovering through February and March. The Fund had an atypical underperformance versus the small-cap index as stock prices fell in January. This set the stage for a relatively rough first quarter, in which the Fund gained 2.4% versus 4.3% for the Russell 2000. This pattern repeated itself in the second quarter. Special Equity trailed in the brief April downturn—despite the fact that late March saw signs of a shift back to the kind of quality names we own—and lagged as small-caps rallied in May. The last few trading days in June were particularly difficult. The Fund saw a modest secondquarter gain wiped out near the very end of the month, mostly the result of volatility from the Greek default. Special Equity fell 2.9% in the second quarter while its benchmark advanced 0.4%. In general, the benchmark's first-half performance was propelled by Health Care (led by biotech), which in the second quarter was joined by Financials (led by banks). The portfolio was significantly underweight both sectors throughout the first half. Positive results within the benchmark for the semiannual period also came disproportionately from non-earning, lowest ROE quintile, and non-yielding companies, which was not a good lineup for our classic value approach to be competing with.

Longer-term results were better on both an absolute and relative basis. The Fund essentially tied the Russell 2000 for the 10-year period and outpaced the small-cap index for the 15-year and since inception (5/1/98) periods ended June 30, 2015. Special Equity's average annual total return for the since inception period was 9.4%.

What Worked... And What Didn't

In the first half Consumer Discretionary led all of the Fund's equity sectors by a sizable margin, boosted by strong results from three of the portfolio's top-five contributors. The Children's Place retails valuepriced apparel and accessories for newborn to 12-year old children primarily in the eastern U.S. Scholastic Corporation is a global children's publishing, education, and media company that produces and distributes educational materials for use in school and at home. The Finish Line is a specialty retailer of athletic shoes and sports apparel. The company's stock began a gradual ascent late in the first quarter. In the Industrials sector, long-time holding National Presto Industries also enjoyed a strong first half. The company makes defense products, housewares and small appliances, and absorbent products.

The Information Technology, Industrials, and Materials sectors each ended the semiannual period with net losses, with the first group having by far the biggest negative impact. This was the case on both an absolute and relative basis, as the portfolio's lack of exposure to software companies—the sector's leaders within the Russell 2000— hurt relative results. The Fund's largest detractor at the position level was 2014's top performer and Special Equity's top position at the end of June 2015—UniFirst Corporation, which provides workplace uniforms and protective work wear clothing. Bed Bath & Beyond, the portfolio's second-largest position, was a rare first-half miss in the otherwise robust Consumer Discretionary group. The company operates a nationwide chain of retail stores that sell domestics merchandise, home furnishings, and other goods. Another detractor, L.B. Foster Company manufactures, fabricates, and distributes rail and trackwork piling, highway products, earth wall systems, and tubular products. We held a good-sized stake at the end of the first half.

Current Positioning and Outlook

The Russell 2000's average annual total return for the five-year period ended June 30, 2015 was 17.1%. We believe the regularly required disclosure when speaking of performance, "Past performance is no guarantee of future results," is especially relevant when looking at that figure—in our view this is not the kind of return that investors should expect going forward. In such a market, which has been almost devoid of any meaningful correction, passive strategies have obviously prevailed. If, as we expect, the market becomes more challenging and quality minded, not only will returns be lower, but we will also see down markets. In that kind of environment, we expect to do better. Owning what we believe are great companies bought at reasonable valuations—many of which have increased dividends annually—continues to excite us. It's important to note that in low-growth periods such as the 1940s and 1970s dividends accounted for as much as 75% of the total return for stocks.

Perhaps the best signal that many of the globe's potential trouble spots at the end of June—China, Greece, Puerto Rico, and the seemingly ever-present possibility of terror attacks, to name four examples—seem unlikely to cause harm to the U.S. economy is that consumer confidence remained elevated in sharp contrast to investor sentiment. We believe investors will become more bullish. Taking a full market cycle view, particularly from this level, we feel very comfortable with the portfolio. At the end of the first half, the Fund was substantially overweight in Consumer Discretionary, Consumer Staples, Industrials, and Materials.

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

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

Important Performance, Expense, and Disclosure Information