article 06-30-2016

2016 Semiannual Manager Commentary for Royce Heritage Fund

We anticipate higher market volatility and lower returns, with the result that investors will continue to be more discriminating. For these reasons, among others, we believe our bottom-up, quality-oriented process has the potential to do well, particularly during downdrafts.

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Fund Performance

Royce Heritage Fund gained 5.3% for the year-to-date period ended June 30, 2016, well ahead of the 2.2% increase for its small-cap benchmark, the Russell 2000 Index, for the same period.

We were pleased to see the Fund hold its value more effectively than its benchmark when prices were falling during the bearish phase and to see it participate fully in the initial stage of the rebound after small-caps made a low on February 11.

This made for a strong first quarter on an absolute and relative basis, with Heritage up 4.8% versus a loss of 1.5% for the Russell 2000.

During the second quarter small-cap sector and industry leadership began to shift somewhat, with renewed strength for defensive areas such as utilities and REITs and ongoing vigor for discrete pockets of cyclical businesses, most notably in Industrials and Materials.

This led the Fund to lose some ground to the Russell 2000. Heritage finished the second quarter with a modest gain of 0.4% compared to a 3.8% increase for the small-cap index. We were pleased that Heritage outpaced the Russell 2000 for the one-, 15-, 20-year, and since inception (12/27/95) periods ended June 30, 2016.

The Fund's average annual total return since inception was 12.0%. We remain very proud of this long-term performance record.

What Worked... And What Didn't

Industrials led the list of the Fund's six (of nine) equity sectors to finish the first half in the black, followed by solid contributions from Consumer Discretionary and Materials.

Of the three sectors that detracted from performance, only Financials had a significant negative impact. At the industry level, there was an interesting symmetry.

Two groups made relatively large contributions—commercial services & supplies (Industrials) and auto components (Consumer Discretionary)—while two others, both of which came from Financials, had comparably sizable net losses—real estate management & development and capital markets.

Each of the portfolio's five highest biggest contributors were also top-10 positions at the end of June.

Copart has what we see as a strong niche providing vehicle suppliers, primarily insurance companies, with services to process and sell salvage vehicles through auctions. It has benefited from favorable industry tailwinds, including aging vehicle fleets and the increased cost and complexity of car repairs due to the greater number of computerized parts, which has created higher salvage volumes.

Reliance Steel & Aluminum was helped by a sharp rise in steel and other base metals prices. Strong demand from the auto and aerospace sectors, as well as incremental improvement in commercial construction, continues to underpin solid volume trends, while distributor inventories are lean, with extended mill lead times for some products.

UGI Corporation distributes propane, as well as natural gas and electricity, while also selling related products and services. The company has been managing well enough in a volatile energy market to have raised guidance for fiscal 2016 in May, further igniting an already fast-rising stock price.

Drew Industries supplies components for manufactured homes and recreational vehicles (RVs). The company enjoyed record sales growth for fiscal 2015, fueled by accretive acquisitions, a new supply agreement for electronics, and innovative new products and features for RVs. 2016's fiscal first quarter saw additional acquisitions and earnings improvement.

"We anticipate higher market volatility and lower returns, with the result that investors will continue to be more discriminating. For these reasons, among others, we believe our bottom-up, quality-oriented process has the potential to do well, particularly during downdrafts."

As for detractors, we sold our shares of Signet Jewelers in June. The company, which operates the Jared, Kay, and Zales chains, was hurt by financing concerns that were followed by allegations of precious stone-swapping by its employees.

Two real estate management & development stocks disappointed in the first half, though we took advantage of lower prices and added to both positions.

Global real estate investment company Kennedy Wilson Holdings and Jones Lang LaSalle, which provides real estate brokerage and property management services, have continued to execute well but a deceleration in commercial real estate transaction volumes—mostly related to volatile capital markets in the first half—hurt results for the latter while the former mostly suffered in the wake of Brexit.

The Fund gained most versus its benchmark by our lack of exposure to biotechnology stocks, successful stock picking in Consumer Discretionary, and a combination of our overweight and stock selection in Industrials. Hurting relative results most was ineffective stock picking in Financials, specifically in the aforementioned real estate management & development industry.


Top Contributors to Performance
For 2016 (%)1

Copart 0.72
Reliance Steel & Aluminum 0.68
UGI Corporation 0.68
Drew Industries 0.68
Minerals Technologies 0.48
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Signet Jewelers -0.61
LaSalle Partners Incorporated -0.45
Kennedy-Wilson Holdings -0.45
ManpowerGroup -0.45
Westlake Chemicals -0.44
2 Net of dividends

Current Positioning and Outlook

We anticipate higher market volatility and lower returns, with the result that investors will continue to be more discriminating. For these reasons, among others, we believe our bottom-up, quality-oriented process has the potential to do well, particularly during downdrafts.

During the first half, we continued to reduce the total number of names in the Fund while increasing its domestic focus. Portfolio positioning has otherwise remained largely intact.

Our largest sector weightings at the end of June were Industrials and Consumer Discretionary. We also had a larger weight in Materials and lower exposure to Information Technology, Health Care, Financials, Consumer Staples, and Utilities. Finally, the portfolio had no exposure to Energy and Telecommunication Services.

Average Annual Total Returns Through 6/30/16 (%)

  QTR* 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Heritage 0.52 -2.45 4.14 4.18 5.75 11.71 12.16 12/27/95
Russell 2000 3.79 -6.73 7.09 8.35 6.20 7.61 7.97 N/A
Annual Operating Expenses: 1.01%

*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. All performance and risk information reflects results of the Service Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Service Class as of the Fund’s most current prospectus and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Shares of RHF’s Consultant and R Classes bear an annual distribution expense that is higher than that of the Service Class. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. 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 2016.

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, 2016, 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, 2016 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.

As of 6/30/16, Copart was 2.7% of net assets, Reliance Steel & Aluminum was 2.4%, UGI Corporation was 2.1%, Drew Industries was 2.2%, Signet Jewelers was 0.0%, Kennedy-Wilson Holdings was 1.8% and Jones Lang LaSalle was 1.5%.

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 generally invests a significant portion of its assets in small-cap and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 35% 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 2000 Index 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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