article 06-30-2016

2016 Semiannual Manager Commentary for Royce Total Return Fund

Portfolio Managers Chuck Royce and Jay Kaplan continue to believe that an extended period of slow growth should be enough to keep profitable cyclicals climbing, especially after factoring in the ways in which low expectations and—for some industries—oversold conditions depressed the stock prices of so many small-caps that we see as well-managed, conservatively capitalized businesses.

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Fund Performance

Royce Total Return Fund gained 8.6% for the year-to-date period ended June 30, 2016, well ahead of the 2.2% increase for its small-cap benchmark, the Russell 2000 Index, for the same period.

The Fund benefited in the first quarter from the long-awaited shift in the small-cap market towards companies with current earnings, below-average risk profiles, and lower valuations, all aspects that fit well with the Fund's strategy. For the first quarter, Total Return rose 5.2% while the small-cap index fell 1.5%.

The second quarter saw recoveries for many areas of the small-cap market that had been hardest hit in the first-quarter downdraft, and the Fund lost a small bit of ground to the benchmark in the period.

For the second quarter, Total Return climbed 3.3% while the Russell 2000 gained 3.8%. In addition to our satisfaction with the Fund's first-half results, we were pleased that the Fund maintained a relative edge in longer-term periods.

Total Return outpaced the Russell 2000 for the one-, 15-, 20-year, and since inception (12/15/93) periods ended June 30, 2016. Its average annual total return since inception was 10.5%, a notable result that makes us quite proud.

What Worked... And What Didn't

We were also pleased to see each of the Fund's 10 equity sectors finish the semiannual period with net gains, which is a little better than the index, in which nine of 10 sectors contributed.

"We continue to believe that an extended period of slow growth should be enough to keep profitable cyclicals climbing, especially after factoring in the ways in which low expectations and—for some industries—oversold conditions depressed the stock prices of so many small-caps that we see as well-managed, conservatively capitalized businesses."

While three of the Fund's sectors posted notable net gains, Materials led by a substantial margin, followed by Industrials and Financials.

Similarly, three industry groups made relatively outsized contributions—commercial services & supplies (Industrials), chemicals, and metals & mining (both from Materials). Unsurprisingly, net losses at the industry level were modest, with capital markets (Financials) and professional services (Industrials) detracting most.

Long-time holding Ritchie Bros. Auctioneers was the Fund's top performer in the first half. The company runs what we have long believed is an attractive niche business auctioning industrial equipment in the construction, transportation, and agricultural industries. Impressive revenue growth has driven earnings improvement. We like its dividend, ability to generate free cash flow, global reach, and growing online presence. It was the Fund's largest holding at the end of June.

Top-20 holding Chase Corporation manufactures protective coatings and tape products for various industrial applications. Earnings and operating results have gradually improved so far in 2016, with increased demand spurring growth.

Albemarle Corporation is another chemical business that enjoyed a strong first half. The Fund's eleventh largest holding at the end of June, the company produces specialty chemicals mostly for plastics and polymers. While revenue growth has been challenged, earnings improved steadily over the last four fiscal quarters, attracting more investors to the stock.

The leading contributor in the Financials sector, TMX Group owns and operates the Toronto Stock Exchange. The company lowered operating expenses to offset lower revenues, which helped to boost profits in its fiscal first quarter.

Net losses at the position level were comparatively modest. Shares of staffing specialist ManpowerGroup were hurt by Brexit. Its stock then enjoyed little of the recovery that lifted many other U.S. companies later in June, largely owing to the company's significant exposure to the European labor market. Thinking it was oversold, we held a good-sized position at the end of the first half.

SEI Investments is an asset manager that also provides technology solutions. We have long liked its core businesses, but saw what we thought was better value elsewhere and exited our position in March.

Relative to the Russell 2000, the Fund's strongest sector was Health Care, thanks to our significant underweight in biotechnology and, to a lesser degree, effective stock picking in health care equipment & supplies.

Our greater exposure to Materials also gave the Fund a relative advantage, most notably in the metals & mining and aforementioned chemicals industries.

Stock selection in Energy and Consumer Discretionary also provided a relative edge. Conversely, the Fund's lower exposure to the Utilities sector hurt relative performance, as did our overweight in capital markets and our underweight in REITs, the last of which enjoyed a strong first half. Both industries are in the Financials sector.


Top Contributors to Performance
For 2016 (%)1

Ritchie Bros. Auctioneers 0.48
Chase Corporation  0.45
TMX Group  0.40
Albemarle Corporation 0.36
Teleflex 0.33
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

ManpowerGroup -0.28
SEI Investments -0.18
Korn/Ferry International -0.17
KKR & Co. L.P. -0.16
Diebold -0.16
2 Net of dividends

Current Positioning and Outlook

Financials was the portfolio's largest sector at the end of June. However, our weightings deviate from the ways in which traditional dividend-oriented portfolios often invest in this sector. The two largest industry weightings were insurance—largely via property and casualty underwriters—and capital markets, where the emphasis is on both traditional and alternative asset managers. These weightings give the Fund much less interest rate sensitivity than the index's largest two industries in the sectors REITs and banks.

With interest rates near all-time lows, we are very comfortable with the Fund's lower exposure to these industries. More generally, we continue to believe that an extended period of slow growth should be enough to keep profitable cyclicals climbing, especially after factoring in the ways in which low expectations and—for some industries—oversold conditions depressed the stock prices of so many small-caps that we see as well-managed, conservatively capitalized businesses.

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

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Total Return 3.28 0.07 6.32 7.68 6.16 9.54 10.46 12/15/93
Russell 2000 3.79 -6.73 7.09 8.35 6.20 7.61 8.47 N/A
Annual Operating Expenses: 1.22%

* 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 Investment Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management 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. Shares of RTR’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Investment 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, Ritchie Bros. Auctioneers was 1.5% of the Fund’s net assets, Chase Corporation was 0.9%, Albemarle Corporation was 1.1%, TMX Group was 0.9%, Manpower Group was 0.9%, and SEI Investments was 0.0%.

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 stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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 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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