article 06-30-2016

2016 Semiannual Manager Commentary for Royce International Small-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 small-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 Small-Cap Fund was down 1.6% 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. One of 2015's strongest groups—those in developed Europe—corrected most sharply in the opening quarter.

Although the portfolio's exposure to Western Europe was comparable to that of the benchmark, International Small-Cap nonetheless outperformed, advancing 2.1% compared to a 0.9% gain for the Russell Global ex-U.S. Small Cap. Holdings in Canada and Japan contributed most to first-quarter 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 in this highly volatile period, underperforming the Russell Global ex-U.S. Small Cap in the second quarter, down 3.6% 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 strong quarter on both an absolute and relative basis. International Small-Cap outperformed the Russell Global ex-U.S. Small Cap for the since inception (6/30/08) period ended June 30, 2016.

What Worked... And What Didn't

Six of the Fund's 10 equity sectors finished the first half in the black, with the largest contributions coming from Financials, Consumer Discretionary, and Industrials.

Of the four sectors with net losses, only Information Technology detracted meaningfully from first-half results. The portfolio's top-performing industry was real estate management & development (Financials), a group that more than doubled the respective impacts of auto components and media, the next-best performing groups, which are slotted in the Consumer Discretionary sector.

"Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the small-cap space."

That same sector was home to one the Fund's three biggest detractors at the industry level, specialty retail. IT services and electronic equipment, instruments & components, both from Information Technology, also posted decent-sized net losses.

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. We trimmed our position in the first half. While we have confidence in its long-term prospects, we also anticipate increased volatility in the short run.

We felt less confident in the long-term prospects for Wasion Group Holdings, a Hong Kong-based company that provides smart power, water, heat, and gas meters. Recent earnings have been unsteady primarily due to its reliance on the Chinese government's budgeting, which influenced our decision to move on.

Minth Group was the Fund's largest holding at the end of June and its best-performing holding for the semiannual period. This Chinese auto supplier has seen a steady increase in operating earnings as investments geared toward greater manufacturing efficiencies have paid off.

T4F Entretenimento, another top-10 position, is 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. We think it continues to be vastly undervalued relative to its global peers, mainly because most of its business is in Brazil, which has been going through political and economic difficulties.

Holdings based in Canada had by far the biggest positive impact on first-half results, followed by Brazil, Japan, and China, while the largest detractors on a country basis were the United Kingdom (with Brexit obviously hurting a great deal) and Hong Kong.

Strong Canadian contributors included pension and human resource consultant Morneau Shepell and Magellan Aerospace, which serves the civil aerospace and defense markets.

Relative to the Russell Global ex-U.S. Small Cap, the Fund was hurt most by ineffective stock selection in two Information Technology industries—the previously cited electronic equipment, instruments & components and software—and in food & staples retailing and food products, both in Consumer Staples.

Conversely, stock picking was a strength in thrifts & mortgage finance (Financials) as well as in auto components and textiles, apparel & luxury goods, both in Consumer Discretionary, and in several groups in the Industrials sector.


Top Contributors to Performance
For 2016 (%)1

Minth Group  0.97
T4F Entretenimento 0.85
Morneau Shepell 0.58
Manappuram Finance 0.53
Magellan Aerospace 0.48
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Banca Sistema -0.62
Wasion Group Holdings -0.50
Texwinca Holdings -0.47
SPARX Group -0.34
Net 1 UEPS Technologies -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 small-caps.

In Japan, negative interest rates, as well as 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 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
International Small-Cap -3.63 -7.29 0.78 -0.97 N/A N/A 3.43 06/30/08
Russell Glo x US SC 0.09 -5.77 4.06 1.91 3.82 N/A 2.77 N/A
Annual Operating Expenses: Gross 3.98% Net 1.20

*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 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. All performance and risk information reflects results of the Service Class (its oldest class). Gross operating expenses reflect total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, and other 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 1.54% through April 30, 2017. 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 0.7% of the Fund’s net assets, Wasion Group Holdings was 0.0%, Minth Group was 2.1%, T4F Entretenimento was 1.9%, Morneau Shepell was 0.9%, 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, currency 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.) In addition, as of 6/30/15 the Fund invested 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 of these stocks would cause the Fund’s overall value to decline to a greater degree. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (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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