article 06-30-2016

2016 Semiannual Manager Commentary for Royce 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 Opportunity Fund advanced 3.2% for the year-to-date period ended June 30, 2016, outperforming its small-cap benchmark, the Russell 2000 Index, which was up 2.2% for the same period.

The positive low returns in the first half belie the wildly volatile nature of the small-cap market during this time. As small-cap stocks entered bear territory in mid-February before coming back strong to end 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 (+2.1% versus -1.5%), as investors shifted 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 and before resuming through the end of June.

The Fund gave up some ground to its small-cap benchmark in this period, underperforming in the second quarter with a gain of 1.1% compared to 3.8% for the Russell 2000. We remain confident, however, in the portfolio's theme-driven deep value approach as we look out to the rest of 2016 and beyond.

We were also pleased that Opportunity Fund outpaced the small-cap index for the 15-year and since inception (11/19/96) periods ended June 30, 2016. The Fund's average annual total return since inception was 11.3%, a long-term record that gives us great pride.

What Worked... And What Didn't

Six of the Fund's 10 equity sectors made contributions to first-half performance, while a seventh—Utilities, where we typically have very little exposure—was flat.

Materials and Industrials led by a wide margin, followed by Information Technology. Health Care and Consumer Discretionary detracted most, while net losses in Energy were comparatively modest. Five industry groups posted significant net gains—metals & mining, chemicals (both from Materials), electronic equipment, instruments & components, semiconductors & semiconductor equipment (both from Information Technology), and machinery (Industrials).

Net losses at the industry level were relatively small, with Internet software & services, IT services (both from Information Technology), specialty retail (Consumer Discretionary), and communications equipment (Information Technology) detracting most.

Most of the portfolio's successes in the first half were the result of opportunities we pursued in 2015 or earlier, when valuations looked attractively low and the potential for earnings recovery was promising.

As is always the case, we were prepared to wait for growth catalysts, usually in the form of earnings improvement, to take effect. Kraton Performance Polymers produces engineered polymers, styrenic block copolymers, and specialty products primarily derived from renewable sources. We first bought shares in 2013, gradually building our stake as its management engineered a turnaround. Two consecutive quarters of better-than-expected earnings and an accretive acquisition in January 2016 helped to fuel the right reaction from investors. We reduced our position throughout the first half.

"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."

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

Astec Industries makes and finances equipment and components used primarily in road building and related construction activities. Its shares cruised on improved earnings and an increased backlog of business helped by a federal highway bill. We trimmed our shares in the first half.

We were still waiting for improvements to revenues and/or earnings for the portfolio’s biggest detractors at the position level.

Monster Worldwide is a global online employment solutions company. Its shares declined precipitously in February after it announced strong earnings on disappointing revenues, especially on some of the firm's newer products.

TRC Companies provides technical, financial risk management, and construction services to the public and private sectors. Its acquisition of an oil and gas pipeline services company was made when energy prices were still falling, and the market's response was predictably negative. After some trimming, we still held shares in both stocks at the end of June.

We chose to add to our position in Albany Molecular. Its stock was volatile but mostly down in the first half, thanks to disappointing losses. Its earnings history has historically been fairly lumpy, and we feel strongly about the growth potential in its niche offering various contract chemical research and development services.

Relative to its benchmark, the Fund benefited from both its overweight and effective stock selection in Materials, specifically its larger exposure to metals & mining companies and more successful picks in chemical companies. Our lack of exposure to biotechnology stocks was also a significant source of relative outperformance.

Ineffective stock selection hampered relative results in two areas of Consumer Discretionary—household durables and specialty retail—while the portfolio's lack of exposure to Utilities also hurt.


Top Contributors to Performance
For 2016 (%)1

Kraton Performance Polymers 0.60
Newport Corporation 0.49
Astec Industries 0.37
Pan American Silver 0.36
Mueller Water Products Cl. A 0.35
1 Includes dividends

Top Detractors from Performance
For 2016(%)2

Monster Worldwide -0.45
TRC Companies -0.36
Albany Molecular Research -0.32
Invacare Corporation -0.31
CIBER -0.30
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 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Opportunity 1.11 -11.38 2.45 5.80 5.43 N/A 11.30 11/19/96
Russell 2000 3.79 -6.73 7.09 8.35 6.20 7.61 7.73 N/A
Annual Operating Expenses: 1.17%

* 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 Investment Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. 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. Shares of ROF’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Investment Class. 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, Kraton Performance Polymers was 1.2% of the Fund’s net assets, Newport Corporation was 0.0%, Astec Industries was 1.0%, Monster Worldwide was 0.2%, and TRC Companies was 0.6%.

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 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.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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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