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.

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.

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 (%)

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

Important Performance, Expense, and Disclosure Information