article 06-30-2016

2016 Semiannual Manager Commentary for Royce Small-Cap Leaders Fund

We remain encouraged about the potential for the Fund's quality-centric approach, which focuses on what we think are leading small-cap companies that have strong business models and competitive positions, superior balance sheets, and attractive prospects for growth. 

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Fund Performance

Royce Small-Cap Value Fund advanced 6.0% for the year-to-date period ended June 30, 2016, ahead of its small-cap benchmark, the Russell 2000 Index, which was up 2.2% for the same period.

The Fund held up well through a volatile first half, especially during the first quarter when small-caps experienced long-awaited reversals in favor of companies with positive earnings, better balance sheets, and higher profitability, all of which fit well with the Fund's strategy. Small-Cap Leaders gained 5.2% in the first quarter compared to a decline of 1.5% for the small-cap index.

Late in the second quarter, the Brexit decision generated a quick surge of high volatility for markets across the globe. Yet after a few bearish sessions, the U.S. equity markets resumed their previously slow steady pace of growth.

The Fund delivered a modest positive return in the second quarter, up 0.8% compared to 3.8% for the Russell 2000. We remain encouraged about the potential for the Fund's quality-centric approach, which focuses on what we think are leading small-cap companies that have strong business models and competitive positions, superior balance sheets, and attractive prospects for growth.

Small-Cap Leaders' average annual total return for the since inception (6/30/03) period ended June 30, 2016 was 8.7%.

What Worked... And What Didn't

Industrials and Information Technology were well out in front, leading seven of the Fund's eight equity sectors that finished the first half in the black. Three industry groups posted notable net gains—electronic equipment, instruments & components, semiconductors & semiconductor equipment, both Information Technology areas, and thrifts & mortgage finance from Financials.

"We remain encouraged about the potential for the Fund's quality-centric approach, which focuses on what we think are leading small-cap companies that have strong business models and competitive positions, superior balance sheets, and attractive prospects for growth."

That third industry is home to Genworth MI Canada, that country's leading residential mortgage insurance provider. Its stock rebounded with consecutive quarters of strong results which were driven by a loss ratio that remains below the low end of its guidance. This has eased investor anxieties about the impact of lower oil prices in resource-rich Alberta, where about 20% of its policies are written. The recovery in oil prices also helped its shares to surge. Even with its recovery, the company was still recently priced below tangible book value and has a nearly 5% dividend yield, factors that contributed to it being the Fund's largest holding at the end of June.

Other top performers included Minerals Technologies, a beneficiary of improved investor sentiment toward global industrials following the Russell 2000's first-half low on February 11. The company continues to build a pipeline of exclusive deals to supply precipitated calcium carbonate to paper producers, primarily in China, while the recent pick-up in steel prices bodes well for its refractories sales. Management also continues to do an exceptional job managing costs and improving the profitability of several acquired businesses.

Negative sentiment toward the end of 2015 weighed down the prices of trucking stocks, including less-than-truckload provider Saia, a top-10 holding. The company has subsequently delivered better-than-industry results thanks to its ongoing rate improvement and fleet management moves.

Fabrinet is one of the few contract manufacturers focused exclusively on optical networking communications equipment. The company has reported excellent results as its key customers—telecomm service providers and data center operators—are upgrading their infrastructure with optical components to handle the explosive growth in Internet data traffic.

Three asset managers headed the list of positions that detracted. Virtus Investment Partners had to cope with the departure of a key portfolio manager from one of its best-performing and asset-attracting funds. While no doubt a loss, the magnitude of outflows may prove less severe than the market has priced in. We think the portfolio at issue remains in highly capable hands—the right-hand man of the departed manager—along with a strong analytical team. We added shares in the first half.

Both the downdraft early in 2016 and the Brexit-bred volatility in late June pressured the shares of Lazard as increased uncertainty about global growth slowed the pace of merger and acquisition activity that is one of its key specialties. Investors also seemed sensitive to the firm's greater exposure to international and, more specifically, emerging market funds.

The same waves of volatility hurt Artisan Partners Asset Management, stoking concerns about the impact on earnings of slower or negative net fund flows and reduced assets under management. We like each company's long-term prospects.

The Fund's relative advantages versus the Russell 2000 included our significant underweight in Health Care and superior stock selection in that sector's life sciences tools & sciences group. We were also helped by better stock picking in our two leading industries in Information Technology and the road & rail group in Industrials.

Conversely, we were hurt in the first half by our much larger weighting in capital markets. Also hampering relative returns was our lack of exposure to REITs and the Utilities sector as these interest-rate sensitive stocks rallied as bond yields fell.


Top Contributors to Performance
For 2016 (%)1

Genworth MI Canada 1.05
Minerals Technologies 0.70
Saia 0.65
Fabrinet 0.62
Bio-Techne 0.62
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Virtus Investment Partners -1.13
Lazard Cl. A -0.87
Artisan Partners Asset Management Cl. A -0.60
TrueBlue -0.48
Federal Signal  -0.42
2 Net of dividends

Current Positioning and Outlook

Portfolio positioning remains largely intact. We continue to see the greatest values in leading companies in cyclically sensitive areas, particularly those within the industrial part of the economy.

Our largest sector weightings in Industrials and Information Technology reflect this view. Moreover, while the Fund rarely has holdings among REITs, Utilities, and Telecommunication Services stocks, with Treasury Bond yields at historic lows, we are very comfortable with the Fund’s lack of exposure here.

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

  QTR YTD 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Small-Cap Leaders 0.76 6.05 -6.90 2.27 3.33 5.83 N/A 8.84 06/30/03
Russell 2000 3.79 2.22 -6.73 7.09 8.35 6.20 7.61 8.96 N/A
Annual Operating Expenses: 1.24%

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 Service Class (its oldest class). Gross operating expenses reflect the Fund's gross total annual operating expenses for the Service Class 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 fees and/or reimburse operating expenses to the extent necessary to maintain the Service Class’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 1.49% through April 30, 2017. Shares of ROH’s R Class bear an annual distribution expense that is higher than that of the Service 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, Genworth MI Canada was 2.9% of the Fund’s net assets, Minerals Technologies was 1.6%, Saia was 2.6%, Fabrinet was 0.8%, Virtus Investment Partners was 1.6%, Lazard was 1.9%, and Artisan Partners Asset Management was 1.2%.   

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. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than 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.) 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 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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