article 06-30-2016

2016 Semiannual Manager Commentary for Royce Micro-Cap Opportunity Fund

We believe that the U.S. economy will continue to grow, and our industry focus has been on areas such as residential and non-residential construction, defense, and discrete consumer industries, where we think positive trends in employment and wage growth should ultimately prove rewarding for these companies.

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Fund Performance

Royce Micro-Cap Opportunity Fund advanced 3.2% for the year-to-date period ended June 30, 2016, outperforming its benchmark, the Russell Microcap Index, which lost 1.7% for the same period.

The positive low returns for the first half of 2016 belie the wildly volatile nature of the small-cap market during this time. As micro- and small-cap stocks entered bear territory in mid-February before coming back strong to finish the first quarter, market leadership shifted more definitively from growth to value. These dramatic moves helped the Fund to outperform its benchmark in the first quarter (-0.9% versus -5.4%), as investors moved away from the narrow areas that were successful in 2015 and began to focus on areas that had been mostly overlooked.

The second quarter offered its own drama in the form of Brexit, but the modestly bullish pace of returns was impeded only briefly before resuming through the end of June. The Fund gained a bit more ground on its micro-cap benchmark in this period, gaining 4.1% compared to 4.0% for the Russell Microcap.

We remain confident in the portfolio's theme-driven deep value approach as we look out to the rest of 2016 and beyond. We were also pleased with the Fund's 9.9% average annual total return since inception (8/31/10).

What Worked... And What Didn't

Four of the Fund's nine equity sectors finished the first half in the black. Information Technology—the portfolio’s largest sector—posted net gains well in excess of Industrials, the next-best performer.

Of the five sectors in the red at the end of June, only Health Care detracted meaningfully from first-half performance. The electronic equipment, instruments & components group led all of the portfolio's industries by a sizable margin, followed by semiconductors & semiconductor equipment (both from Information Technology), and aerospace & defense (Industrials).

"We believe that the U.S. economy will continue to grow, and our industry focus has been on areas such as residential and non-residential construction, defense, and discrete consumer industries, where we think positive trends in employment and wage growth should ultimately prove rewarding for these companies."

Health Care was home to three of the Fund's four biggest detracting industry groups—health care providers & services, health care equipment & supplies, and biotechnology. Software rounded out the top four. Net losses at the industry level were comparatively modest.

Amber Road, the Fund's top performing—and largest—holding in the first half, is a software company with a compelling niche. It develops single platforms to automate and streamline global trades, offering import and export, global logistics, and trade agreement management solutions. We first bought shares in 2014 on the understanding that its turnaround would take time and patience. In the first half of 2016, investors seemed to be anticipating greater acceptance of its product, driving up the value of its shares.

Newport Corporation became one of several acquisition targets in the portfolio when MKS Instruments announced in February that it would be buying the business of this specialty electronic component maker for a significant premium. We sold our shares shortly after the announcement.

KEYW Holding Corporation is another top-10 position that enjoyed a strong first half. The company makes software that collects, processes, and analyses intelligence data and information in cyberspace. We see cybersecurity as a major growth area and were pleased to see this largely underfollowed company command attention as it sold off a business to better focus on what we see as its core strength.

As for positions that detracted from performance, the most impactful was SunEdison, which makes semiconductors and solar energy technology. After the company suffered through months of disappointing developments dating back to 2015, we decided to sell our position during February and March of this year.

We had the opposite view about the long-term prospects for Civitas Solutions, which provides home and community based health and human services to people with intellectual, developmental, physical or behavioral disabilities, and other special needs. We thought its valuation looked highly attractive when we gradually began to build our position in the spring of 2015. Its share price proceeded to appreciate through the second half of 2015 before correcting dramatically earlier this year, giving us a buying opportunity. We like its niche in what we see as a healthcare segment with ample growth potential.

Relative to the Russell Microcap, the Fund benefited significantly from superior stock selection in Information Technology, particularly in the aforementioned electronic equipment, instruments & components group and in communications equipment. Better stock picking also helped in Industrials, especially in the overweighted aerospace & defense and machinery groups.

In addition, the Fund's lower exposure to biotechnology stocks was a source of relative outperformance in Health Care, where stock selection also helped. Ineffective stock selection hampered relative results in two areas of Consumer Discretionary—hotels, restaurants & leisure and household durables—while the portfolio's lack of exposure to Utilities also hurt.


Top Contributors to Performance
For 2016 (%)1

Amber Road 1.10
Newport Corporation 0.95
KEYW Holding Corporation 0.83
Pengrowth Energy 0.82
Spartan Motors 0.81
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

SunEdison -0.58
Civitas Solutions -0.55
TRC Corporation -0.55
Monster Worldwide -0.55
CareDx -0.55
2 Net of dividends

Current Positioning and Outlook

The Fund's largest weightings at the end of June were Information Technology and Industrials. We also had relatively larger weightings in Consumer Discretionary and Materials.

These positions were consistent with our belief that the U.S. economy will continue to grow, and our industry focus has been on areas such as residential and non-residential construction, defense, and discrete consumer industries, where we think positive trends in employment and wage growth should ultimately prove rewarding for these companies.

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

  QTR YTD 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Micro-Cap Opportunity 4.15 3.17 -16.89 0.35 6.18 N/A N/A 9.89 08/31/10
Russell Microcap 3.97 -1.68 -12.06 5.95 8.20 4.31 N/A 13.04 N/A
Russell 2000 3.79 2.22 -6.73 7.09 8.35 6.20 7.61 13.33 N/A
Annual Operating Expenses: Gross 1.39% Net 1.25

* 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. Gross operating expenses reflect the Fund’s total gross annual operating expenses and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Funds most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, (excluding dividend and interest expenses relating to short sale activities, 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 1.24% through April 30, 2017 and at or below 1.99% through April 30, 2025. 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, Amber Road was 3.0% of the Fund’s net assets, Newport Corporation was 0.0%, KEYW Holding Corporation was 1.7%, SunEdison was 1.4%, and Civitas Solutions was 1.6%.

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 invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund 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 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.) The Fund may invest up to 25% 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 Microcap Index includes 1000 of the smallest securities in the small-cap Russell 2000 Index. The Russell 2000 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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