article 06-30-2016

2016 Semiannual Manager Commentary for Royce Special Equity Multi-Cap Fund

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. Yield and total return, along with the importance of compounding, remain critical to generating solid long-term results. To do this, one needs to avoid the free fall and seek low volatility strategies.

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Fund Performance

Royce Special Equity Multi-Cap Fund's highly concentrated portfolio was down 0.5% for the year-to-date period ended June 30, 2016, trailing its large-cap benchmark, the Russell 1000 Index, which was up 3.7% for the same period.

Our frustration was rooted not only in underperformance but also in the way in which the semiannual period played out. The first quarter saw investors begin to focus on the kind of attributes we seek—low leverage, high ROIC (returns on invested capital), and strong cash flows.

This was a long overdue development in our view, and we were pleased to see the Fund outpace its benchmark for the quarter, advancing 6.1% versus 1.2% for the Russell 1000. 

Unfortunately, much of this reversed in the second quarter, which, along with a steep correction for retailers, combined to undo all of the first quarter's gains, and then some.

Most of the market's strength came from REITs, Utilities, and Consumer Staples, as well as from low ROE (return on equity), highly levered, and/or high sales growth companies—not the kind of businesses typically found in the portfolio.

For the second quarter, the Fund fell 6.2% while the large-cap index increased 2.5%. The Fund's average annual total return since inception (12/31/10) was 8.1%.

What Worked... And What Didn't

The bulk of the portfolio's performance in the first half came from Industrials, which posted net gains more than five times greater than those in Financials, its second-best performing sector.

Four of the six top-contributing industry groups came from Industrials. Machinery led by a substantial margin, boosted by strong results for Illinois Tool Works, which produces industrial fluids and adhesives, tooling for specialty applications, welding products, and measurement equipment and systems.

"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 management's outlook in a slow-growth world. Obviously, the increases have to be internally funded. Yield and total return, along with the importance of compounding, remain critical to generating solid long-term results. To do this, one needs to avoid the free fall and seek low volatility strategies."

Parker Hannifin, a maker of motion control products, also enjoyed a strong first half. From the trading companies & distributors group, W.W. Grainger distributes motors, HVAC equipment, lighting, hand and power tools, pumps, and electrical equipment. For all the strength exhibited from Industrials, the portfolio's two biggest contributors were Consumer Discretionary holdings.

Genuine Parts distributes automotive and industrial replacement parts, office products, and electrical and electronic materials. Sporting goods retailer Dicks Sporting Goods operates stores primarily in the eastern and central U.S. selling a broad selection of brand name sporting goods equipment, apparel, and footwear.

Both Industrials and Consumer Discretionary were also home to the portfolio's largest detractors. Staffing and workforce solutions specialist ManpowerGroup saw its shares plummet in the wake of Brexit, mostly due to the company's significant exposure to the European labor market.

Robert Half International is in a similar business; it provides temporary and permanent staffing for several professions, including accounting and finance, information technology, advertising, and legal.

Many specialty and multiline retailers endured a very challenging second quarter, and core holding Nordstrom, a fashion retailer of apparel, shoes, and accessories for men, women, and children, was no exception.

Lear Corporation makes automobile parts, including seating systems, wiring harnesses, and body control electronics. Ralph Lauren designs and distributes men's, women’s and children’s apparel, accessories, fragrances, and home furnishings.

Hurting relative results in the first half were ineffective stock selection in Industrials, a combination of our overweight and poor stock selection in Consumer Discretionary, and our lack of exposure to Consumer Staples, Utilities, Energy, and Telecommunication Services.

Conversely, our lack of exposure to Health Care helped, as did our underweight and, to a lesser extent, stock picking in Financials.


Top Contributors to Performance
For 2016 (%)1

Genuine Parts 1.24
Dicks Sporting Goods 0.95
Illinois Tool Works  0.69
W.W. Grainger  0.46
Parker Hannifin 0.46
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

ManpowerGroup -1.65
Nordstrom  -1.32
Lear Corporation -0.90
Robert Half International -0.69
Ralph Lauren Cl.A -0.57
2 Net of dividends

Current 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.

In this environment, the Fund's two largest sectors at the end of June—Industrials and Consumer Discretionary—were also significantly overweighted compared to the Russell 1000. We also had a good-sized exposure to Information Technology, though the portfolio's exposure was lower than that of its benchmark.

We held no positions in Consumer Staples, Energy, Health Care, Materials, Telecommunication Services, or Utilities and had only modest exposure to Financials.

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. Yield and total return, along with the importance of compounding, remain critical to generating solid long-term results. To do this, one needs to avoid the free fall and seek low volatility strategies.

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

  QTR* 1YR 3YR 5YR SINCE
INCEPT.
DATE
Special Equity Multi-Cap -6.18 -11.07 3.05 7.49 N/A 8.25 12/31/10
Russell 1000 2.54 2.93 11.48 11.88 7.51 12.01 N/A
Annual Operating Expenses: 1.01%
*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). Gross operating expenses reflect gross total annual operating expenses for the Service Class 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 the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Net operating expenses reflect contractual fee waivers and/or 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 Classes' 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 1.24% through April 30, 2017. 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, Illinois Tool Works was 6.1% of the Fund’s net assets, Parker Hannifin was 4.6%, W.W. Grainger was 4.1%, Genuine Parts was 7.5%, Dicks Sporting Goods was 4.6%, ManpowerGroup was 5.8%, Robert Half International was 5.6%, Nordstrom was 5.1%, and Lear Corporation was 1.9%, and Ralph Lauren was 4.0%. 

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 mid-cap and large-cap stocks. The Fund's investments in mid-cap stock may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund generally invests 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 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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