article 06-30-2016

2016 Semiannual Manager Commentary for Royce Small-Cap Value Fund

We should continue to see higher volatility and low returns for stocks. Earnings growth will remain challenging. The U.S. economy continues to limp along while the strengthening U.S. dollar hurts exporters already facing heightened economic uncertainty in Europe. This helps to explains why the yield curve continues to flatten, with the 10-year Treasury making new lows—the bond market is not excited about the U.S. economy. We think the current low-expectation environment can create more long-term opportunities for our contrarian approach.

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Fund Performance

Royce Small-Cap Value Fund was up 3.3% for the year-to-date period ended June 30, 2016, outpacing its small-cap benchmark, the Russell 2000 Index, which advanced 2.2% for the same period.

It was very much a "Tale of Two Quarters" for both the Fund and the small-cap index, and each split the first half of 2016 with very different stories. Featuring a significant correction and increased volatility, the first quarter proved rewarding for strategies focused on valuation, profitability, and out-of-favor companies.

Small-cap Value cemented its leadership over small-cap growth, and the Fund handily outperformed its benchmark, up 9.3% versus a loss of 1.5%.

The second quarter then reversed some—though by no means all—of this encouraging trend, as defensive areas such as REITs and utilities roared back (along with certain high-growth and cyclical areas) while small-cap retailers, where the portfolio was significantly overweight, suffered a major correction.

The result was a loss of 5.5% for the Fund while the Russell 2000 came back with a 3.8% gain in the second quarter. So while we were pleased with first-half performance overall, the second quarter was a frustrating period.

We were also were pleased that the Fund beat the Russell 2000 for the 15-year and since inception (6/14/01) periods ended June 30, 2016. Royce Small-Cap Value's average annual total return since inception was 9.1%.

What Worked... And What Didn't

Four of the Fund's eight equity sectors made positive contributions to first-half performance. Information Technology made by far the biggest impact, more than doubling the net gain of Financials, the portfolio's next-best performer.

Consumer Staples also made a solid contribution. The electronic equipment, instruments & components group led all of the portfolio's industry groups, thanks largely to terrific results for Fabrinet, which provides outsourced manufacturing to original equipment manufacturers of fiber optical communications and other components. The company has benefited from a vibrant cycle for fiber-driven telecommunications upgrades, most recently spurred by the growth of data centers and cloud computing. We reduced our position as its stock price climbed.

"We should continue to see higher volatility and low returns for stocks. Earnings growth will remain challenging. The U.S. economy continues to limp along while the strengthening U.S. dollar hurts exporters already facing heightened economic uncertainty in Europe. This helps to explains why the yield curve continues to flatten, with the 10-year Treasury making new lows—the bond market is not excited about the U.S. economy. We think the current low-expectation environment can create more long-term opportunities for our contrarian approach."

One of 2015's biggest detractors, Genworth MI Canada, saw some welcome recovery in the first half. A residential mortgage insurer, its shares often move with the direction of energy prices. Mortgage losses in energy-dominated western Canada proved to be not nearly as dire as many were anticipating, which helped to bring buyers back to its stock. We trimmed our stake in the first half, though we think its recovery is still in its early stages.

Alamo Group has been executing very effectively, helping its shares to rise. The company makes heavy-duty, tractor-mounted mowing and vegetation maintenance equipment and replacement parts for industrial and agricultural end-users. Its industrial and municipal businesses have been doing well—the budgets of many states, cities, and towns are stable or growing a bit—while its agricultural business has been sound on an absolute basis but strong in relation to its competitors. All of this helped to give it record-setting net sales and income in the fiscal first quarter.

The business of Korn/Ferry International, which provides executive recruiting and other related services, decelerated amid concerns that the robust hiring cycle was turning and the uncertain global outlook in the wake of Brexit. We like its core business and believe its shares were oversold.

Matrix Service is slotted in Energy, though we see it as more of an industrial engineering and construction company. Though it has a sizable exposure to energy that centers on large-scale construction projects, it also serves other industries. Still, it often trades in tandem with oil and gas price sentiment and its shares mostly felt the effects of revised downward guidance issued in May and a series of write offs the firm did for project overruns. We held our shares. Matrix has a strong backlog of business in infrastructure and physical plant projects that we think can create shareholder value in the months ahead.

Relative to the Russell 2000, the Fund benefited most from effective stock selection in Information Technology and its underweight in biotechnology stocks. Stock picking was also a relative strength in thrifts & mortgage finance and food & staples retailing.

Conversely, ineffective stock picks hurt in professional services (Industrials) and multiline retail while our lack of exposure to Utilities (a strong performer in the index) and our overweight in Consumer Discretionary also hampered relative results.


Top Contributors to Performance
For 2016(%)1

Fabrinet  0.94
Genworth MI Canada 0.93
Alamo Group 0.60
Super Micro Computer 0.50
The Fresh Market 0.48
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Matrix Service -0.67
Korn/Ferry International -0.62
Moelis & Company Cl. A -0.51
Express -0.51
Federal Signal -0.49
2 Net of dividends

Current Positioning and Outlook

We believe there will continue to be higher volatility and low returns for stocks. Earnings growth will remain challenging.

The U.S. economy continues to limp along while the strengthening U.S. dollar hurts exporters already facing heightened economic uncertainty in Europe. This helps to explains why the yield curve continues to flatten, with the 10-year Treasury making new lows—the bond market is not excited about the U.S. economy.

Small-cap valuations no longer look cheap except in underperforming areas such as specialty retail in Consumer Discretionary, where we continue to invest and remained overweight at the end of June.

We think the current low-expectation environment can create more long-term opportunities for our contrarian approach.

It should therefore come as no surprise to our investors that our activities have centered on building our exposure to out-of-favor areas such as professional services, road & rail (both in Industrials), and banks.

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

  QTR 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE
Small-Cap Value -5.54 -9.37 2.73 2.47 5.09 9.23 06/14/01
Russell 2000 3.79 -6.73 7.09 8.35 6.20 7.19 N/A
Annual Operating Expenses: 1.23%

* 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 Service Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Service Class as of the Fund’s most current prospectus and include management fees, 12b-1 distribution and service fees, and other expenses. Shares of RVV’s Consultant and R Classes 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, Fabrinet was 0.4% of the Fund’s net assets, Genworth MI Canada was 3.0%, Alamo Group was 2.0%, Korn/Ferry International was 1.4%, and Matrix Service was 2.6%.

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 and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. 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.(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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