Fund Performance

Royce Special Equity Fund gained 8.3% for the year-to-date period ended June 30, 2016, more than tripling the 2.2% return for its benchmark, the Russell 2000 Index, for the same period.

During the volatile first quarter, small-cap value solidified its leadership over growth, having begun to lead in the cycle that kicked off from the Russell 2000's peak on June 23, 2015. The small-cap shift benefited companies with earnings, higher ROE (return on equity), and dividends in the first quarter.

This reversal was both welcome and, in our estimation, long overdue. We were pleased to see the Fund substantially outperform its benchmark in the year's opening quarter, climbing 5.6% versus a loss of 1.5% for its benchmark.

The second quarter saw some of these trends stall or reverse, with most of the market's strength coming from REITs, Utilities, and Consumer Staples, as well as low ROE, highly levered, and/or high sales growth companies—not the kind of businesses typically found in the portfolio.

Still, Special Equity posted a modest positive return in what was an otherwise quietly bullish period aside from the major impact of the Brexit decision. For the second quarter, the Fund advanced 2.5% compared to 3.8% for the Russell 2000.

We were very pleased with Special Equity's strong first half on both an absolute and relative basis and were also happy to see the Fund maintain longer-term relative advantages. The Fund beat the Russell 2000 for the one-, 10-, 15-year, and since inception (5/01/98) periods ended June 30, 2016. Special Equity's average annual total return since inception was 8.6%.

What Worked... And What Didn't

Five of the Fund's six equity sectors posted net gains in the first half. Consumer Discretionary led by a sizable margin, followed by a strong contribution for Industrials. Materials, Consumer Staples, and Information Technology rounded out the list while Financials, the portfolio's lone detractor, posted comparatively minor net losses.

The Consumer Discretionary sector was home to both our two top-performing industry groups—specialty retail and media—as well as household durables, its biggest detractor.

The commercial services & supplies (Industrials), paper & forest products (Materials), and electronic equipment, instruments & components (Information Technology) groups also did well in the first half, while other groups with net losses, such as semiconductors & semiconductor equipment (Information Technology) and capital markets (Financials), made a much smaller impact.

The Fund's top performing contributor by a wide margin was The Children's Place, which retails value-priced apparel and accessories for newborn to 12-year-old children.

Meredith Corporation, an Iowa-based diversified media company involved mainly in publishing and broadcasting, also made a strong contribution, as did South Carolina's AVX Corporation, which manufactures passive electronic components and related products.

UniFirst Corporation provides workplace uniforms and protective clothing while Neenah Paper is a global manufacturer of performance-based papers and specialty products used in a variety of applications.

As for those positions that detracted, Hooker Furniture and Haverty Furniture sell home furnishings; we added shares of each in the first half. We chose to sell our shares of Minerals Technologies, which provides specialty chemicals, early in 2016.

We also parted ways with housewares retailer Bed, Bath & Beyond (along with retailers The Buckle and The Finish Line) while making a modest trim to our position in Teradyne, which makes semiconductor test products and provides related services primarily for the military and aerospace industries.

Relative to the Russell 2000, the Fund's strengths were significantly better stock picking in Consumer Discretionary, an underweight in Health Care, effective stock picks in Materials, and an overweight and strong stock selection in Industrials. Conversely, we were hurt by having no exposure to Utilities and, within Financials, REITs—both of these interest-rate sensitive areas did well when bond yields fell.

Portfolio Positioning and Outlook

In the wake of Brexit, we see interest rates staying low longer and think investors will continue to favor stocks that look like bonds (based on yield and dividend growth) and/or possess attributes that remain scarce, such as stability, free cash flow generation, and good revenue profiles.

Clearly, as always, uncertainty and fear allow for opportunistic purchases, and we intend to make our share. However, we also remain mindful that the overall market is subject to additional Black Swan events, in Japan and China especially, and stocks are far from inexpensive, except perhaps in comparison to sovereign alternatives.

Small-caps, of course, are generally more U.S.-centric and therefore less exposed to the global economy. In this environment, we have seen opportunities in a number of cyclical sectors.

Three of the Fund's four largest at the end of June—Consumer Discretionary, Industrials, and Materials—were also substantially overweighted versus the Russell 2000. The exception was Information Technology, where our good-sized exposure was nonetheless lower than that of the benchmark.

In this era of unknown unknowns, unprecedented events, and obviously heightened uncertainty, we strongly believe our contrarian, skeptical view of things can be beneficial.

We see year-over-year dividend growth as a strong signal of managements' outlook in a slow-growth world. Obviously, the increases have to be internally funded.

Total return and the importance of compounding remain critical in generating strong long-term results. To try to achieve this, we use a low volatility strategy.

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

* Not Annualized

Current month-end performance may be obtained at our Prices and Performance page.

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