article 06-30-2016

2016 Semiannual Manager Commentary for Royce Smaller-Companies Growth Fund

We are more cautious than we have been in some time as we face a number of geopolitical risks, all made more acute by the Brexit vote—Europe is uncertain, China's banking system looks very weak, and Russia continues to rattle its saber. Here in the U.S., the economy is bobbing up and down at the 1-2% level, the Fed is out of stimulative policy ammunition, and the electorate is showing increasing signs of anger and frustration with the political and corporate status quo. 

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Royce Smaller-Companies Growth Fund was down 3.5% for the year-to-date period ended June 30, 2016, trailing its small-cap benchmark, the Russell 2000 Index, which was up 2.2% for the same period.

After losing less than the small-cap index in 2015, the Fund reversed course in the first quarter of 2016, an unpleasant but unsurprising development in light of the steep corrections for biotechnology and other growth industries where the Fund typically invests that impacted small-caps earlier this year. The Fund was behind its benchmark in the first quarter, down 4.4% versus a decline of 1.5%.

Less expected, and therefore more frustrating, was the Fund's less robust participation in the mildly bullish though wildly volatile second quarter. The period saw the headiest comebacks for REITs, utilities, and other defensive areas while it also featured rebounds for certain high-growth stocks and continued strength for a discrete selection of cyclical businesses.

The choppy nature of returns definitely created challenges for our GARP ("growth at a reasonable price") approach. For the second quarter, the Fund advanced 0.9% compared to a 3.8% gain for the Russell 2000.

We were more pleased with longer-term results. Royce Smaller-Companies Growth outperformed its benchmark for the 15-year and since inception (6/14/01) periods ended June 30, 2016. The Fund's average annual total return since inception was 10.5%.

What Worked... And What Didn't

Five of the Fund’s nine equity sectors were in the red at the end of the first half. The most significant net losses came from the Health Care and Information Technology sectors.

Two industry groups within Health Care were the portfolio's biggest detractors in the first half—biotechnology and pharmaceuticals, both of which corrected sharply in the first half. Each industry was also home to one of the Fund's loss leaders at the position level.

Lipocine is an early stage pharmaceuticals company whose shares declined markedly after it failed to receive FDA approval for its lead product candidate, an oral testosterone replacement therapy. We sold our position while awaiting more clarity on any potential progress with the FDA before potentially revisiting the stock.

Zealand Pharma is a Danish biotechnology company whose share price decline was mostly driven by the sell-off in its industry. While we remain optimistic about its long-term growth potential, based in part on the company's partnership with Sanofi in developing a diabetes drug, we reduced our position based on the risks associated with Zealand's increasing dependence on this partnership. 

"We are more cautious than we have been in some time as we face a number of geopolitical risks, all made more acute by the Brexit vote—Europe is uncertain, China's banking system looks very weak, and Russia continues to rattle its saber. Here in the U.S., the economy is bobbing up and down at the 1-2% level, the Fed is out of stimulative policy ammunition, and the electorate is showing increasing signs of anger and frustration with the political and corporate status quo. In addition, valuations for many growth issues looked stretched to us at the end of June. In spite of our near-term concerns, we believe that identifying fast-growing, reasonably priced smaller companies can reward investors over the long term."

The Container Store Group posted the largest net loss at the position level in the first half. We were once confident that the company, a retailer of storage and organizational products, could benefit from its store expansion efforts in an economy with improving employment numbers, confident consumers, low energy prices, and higher levels of new household formation. We sold our position, however, when it became clear to us that management was struggling to make good on this potential in the face of weakening store traffic and the need for a more effective online presence.

SPS Commerce, the biggest detractor in Information Technology, makes cloud-based supply chain management software. A solid contributor in 2015, the company warned of a disappointing revenue outlook for 2016, causing its shares to plummet. We sold our position in March and April.

On the positive side, the Fund's top-contributing position was ORBCOMM, which operates low earth orbit satellites and ground infrastructure that facilitate mobile and other communications. We were pleased to see a successful satellite launch late in 2015, along with solid growth in its business. We reduced our position as its price rose in the first half.

A rising share price also led us to trim our shares of Mercury Systems, which over the last few years has grown into more of a pure play in the defense technology area. The company makes real-time digital signal processors that can transform sensor-generated data into information which can be displayed as images for human interpretation and analysis. Rising revenues and earnings helped attract more interest in its stock.

Relative to the Russell 2000, the Fund was hurt most by ineffective stock picking in Information Technology, with the Internet software & services group and software industry making the biggest negative impact. Financials also hampered relative performance by way of an overweight in capital markets and an underweight in REITs. Conversely, stock picking was a strength in Industrials, Materials, and Energy.


Top Contributors to Performance
For 2016 (%)1

ORBCOMM 0.67
Mercury Systems 0.66
BioTelemetry 0.58
Albemarle Corporation 0.51
PowerSecure International 0.49
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Container Store Group (The) -0.94
Lipocine -0.74
SPS Commerce -0.68
Zealand Pharma  -0.59
comScore -0.58
2 Net of dividends

Current Positioning and Outlook

We are more cautious than we have been in some time as we face a number of geopolitical risks, all made more acute by the Brexit vote—Europe is uncertain, China's banking system looks very weak, and Russia continues to rattle its saber.

Here in the U.S., the economy is bobbing up and down at the 1-2% level, the Fed is out of stimulative policy ammunition, and the electorate is showing increasing signs of anger and frustration with the political and corporate status quo. In addition, valuations for many growth issues looked stretched to us at the end of June.

However, offsetting these concerns to some extent are the following: we also have the globe's steadiest banking system, are seen as a safe haven for investment and, even at its slow pace, a growing economy.

During the first half, we increased our weighting in Energy, believing that commodity prices have bottomed, and added to select positions in Health Care and software.

In spite of our near-term concerns, we believe that identifying fast-growing, reasonably priced smaller companies can reward investors over the long term.

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

  QTR 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE
Smaller-Companies Growth 1.01 -12.78 5.28 5.57 4.59 10.68 06/14/01
Russell 2000 3.79 -6.73 7.09 8.35 6.20 7.19 N/A
Annual Operating Expenses: Gross 1.33 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. 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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of 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 RVP’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, Lipocine was 0.0% of the Fund’s net assets, Zealand Pharma was 1.2%, The Container Store Group was 0.0%, SPS Commerce was 0.0%, ORBCOMM was 1.2%, and Mercury Systems was 2.0%.

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. (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 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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