article 06-30-2016

2016 Semiannual Manager Commentary for Royce International Micro-Cap Fund

Despite continued market volatility, we see pockets of opportunity in several regions. Recent events in the U.K. have led to wide dislocations between the business value and stock price in many European micro-caps. In Japan, negative interest rates, as well ongoing urbanization, have created a positive tailwind for real estate companies while India remains the sole global economy growing in the high single digits. Its finance market is also still relatively immature and should continue to see positive momentum. In addition, we are finding discrete opportunities in businesses affected by the slowdown of the Chinese economy that have used the opportunity to right-size their cost bases to reflect more realistic growth assumptions.

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Fund Performance

Royce International Micro-Cap Fund increased 0.2% for the year-to-date period ended June 30, 2016, trailing its benchmark, the Russell Global ex-U.S. Small Cap Index, which rose 1.0% for the same period.

During the first quarter, results for non-U.S. small-caps were mixed, though mostly muted, with one of 2015's strongest groups—those in developed Europe—correcting most sharply. Although the portfolio's exposure to Western Europe was higher than that of its benchmark, International Micro-Cap nonetheless outperformed, advancing 2.5% compared to a 0.9% gain for the Russell Global ex-U.S. Small Cap. Holdings in Canada and Brazil contributed most to quarterly performance.

The second quarter was moving along in a less volatile, more bullish fashion until the Brexit decision upended many markets, particularly those in the eurozone. By the end of June, most had still not recovered, unlike many of their counterparts in other regions of the globe.

The Fund lost ground this highly volatile period, underperforming the Russell Global ex-U.S. Small Cap in the second quarter, down 2.2% compared to a 0.1% advance for its benchmark. The entirety of its second-quarter loss came during the final week of June—a disappointing end to what had been a modestly positive quarter prior to the Brexit decision. We were pleased, however, that the Fund outperformed its benchmark for the three-year period ended June 30, 2016.

What Worked... And What Didn't

Six of the Fund's eight equity sectors finished the first half with net gains. The biggest contributions came from Consumer Discretionary, Financials, and Materials while Energy and Consumer Staples detracted.

"Despite continued market volatility, we see pockets of opportunity in several regions. Recent events in the U.K. have led to wide dislocations between the business value and stock price in many European micro-caps. In Japan, negative interest rates, as well ongoing urbanization, have created a positive tailwind for real estate companies while India remains the sole global economy growing in the high single digits. Its finance market is also still relatively immature and should continue to see positive momentum. In addition, we are finding discrete opportunities in businesses affected by the slowdown of the Chinese economy that have used the opportunity to right-size their cost bases to reflect more realistic growth assumptions."

The top industry group was media (Consumer Discretionary), followed by real estate management & development (Financials) and semiconductors & semiconductor equipment (Information Technology). The Fund's three largest detractors at the industry level were oil, gas & consumable fuels (Energy), specialty retail (Consumer Discretionary), and banks (Financials).

Banca Sistema is an Italian bank specializing in financing and managing trade receivables owed by the Italian Public Administrations, mainly through factoring and credit management services. Despite its unique business model and attractive growth profile, it has been caught up in the widespread downdraft for Italian banks, considered one of the more vulnerable areas of European finance in the aftermath of Brexit. While we suspect there may be increased volatility in the short run, we added shares based on our confidence in its long-term prospects.

Ardmore Shipping owns and operates shipping tankers, primarily for chemicals. With shipping index volumes bouncing along all-time lows during the first half of the year, its stock was not spared. However, the fact that it was trading at about half its book value near the end of June made Ardmore worth holding as we await a recovery for its industry.

Top-10 position T4F Entretenimento made an impressive contribution to performance in the first half. It's a Brazilian company that operates at multiple levels of the entertainment industry, including venue operation, ticketing, food & beverage, merchandise sales, and corporate sponsorships. The company has exceeded earnings-per-share expectations for the past three quarters. Recent share price appreciation notwithstanding, we think it continues to be vastly undervalued relative to its global peers, mainly because most of its business is in Brazil, which has had political and economic uncertainty over the last couple of years.

Manappuram Finance is an Indian finance company that makes small loans to consumers collateralized by gold. Its shares more than doubled between March and the end of June, mainly the result of achieving synergies from past branch expansion just as gold prices soared. Morneau Shepell is a Canadian pension and human resource consultant that saw new business boosting revenues and earnings in its fiscal first quarter.

Holdings based in Canada had by far the biggest positive impact on first-half results, followed by Brazil, India, and Japan, while the largest detractor by far on a country basis was the United Kingdom (with Brexit obviously hurting a great deal), followed by Italy. In addition to Morneau Shepell, Magellan Aerospace, which serves the civil aerospace and defense markets, was a strong Canadian contributor.

Relative to the Russell Global ex-U.S. Small Cap, the Fund was hurt most by ineffective stock selection in the previously mentioned oil, gas & consumable fuels group and our lighter weighting in the metals & mining industry within Materials. Stock picking and our underweight in Consumer Staples were also factors in underperformance. Conversely, stock picking was a substantial strength in media (Consumer Discretionary), real estate management & development (Financials), and professional services (Industrials).


Top Contributors to Performance
For 2016 (%)1

T4F Entretenimento 1.10
Manappuram Finance 0.52
Morneau Shepell 0.51
Magellan Aerospace 0.39
Webjet 1 0.35
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Banca Sistema -0.66
Ardmore Shipping -0.51
Zealand Pharma -0.41
Pendragon -0.36
SPARX Group -0.34
2 Net of dividends

Current Positioning and Outlook

Despite continued market volatility, we see pockets of opportunity in several regions. Recent events in the U.K. have led to wide dislocations between the business value and stock price in many European micro-caps.

In Japan, negative interest rates, as well ongoing urbanization, have created a positive tailwind for real estate companies while India remains the sole global economy growing in the high single digits. Its finance market is also still relatively immature and should continue to see positive momentum.

In addition, we are finding discrete opportunities in businesses affected by the slowdown of the Chinese economy that have used the opportunity to right-size their cost bases to reflect more realistic growth assumptions.

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

  QTR YTD 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
International Micro-Cap -2.25 0.21 -7.67 5.00 0.20 N/A N/A 0.49 12/31/10
Russell Glo x US SC 0.09 1.01 -5.77 4.06 1.91 3.82 N/A 1.89 N/A
Annual Operating Expenses: Gross 3.11% Net 1.64

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 2% 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 total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund's most current prospectus. Royce & Associates has contractually agreed to waive its fees and/or reimburse operating expenses, to the extent necessary to maintain the Fund’s net annual operating expenses, (excluding 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 1.64% through April 30, 2016 and at or below 1.99% through April 30, 2025. 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, Banca Sistema was 0.9% of the Fund’s net assets, Ardmore Shipping was 0.4%, T4F Entretenimento was 1.1%, Manappuram Finance was 0.9%, Morneau Shepell was 1.0%, and Magellan Aerospace was 2.1%.

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 may invest a significant portion of its assets in foreign companies which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also 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 one 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.) 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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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