Royce Micro-Cap Trust Manager Commentary
article 12-31-2016

Royce Micro-Cap Trust Manager Commentary

Portfolio Manager Chuck Royce and Assistant Portfolio Managers Jim Harvey and Chris Flynn believe cyclicals look well-positioned for ongoing leadership. In addition to their usual cyclical tilt, they are looking in some defensive areas such as healthcare. It is very much on a stock-by-stock basis, with a focus on individual companies that combine attractive valuations with strong fundamentals.

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Fund Performance

Royce Micro-Cap Trust "RMT" advanced 22.0% on a net asset value ("NAV") basis and 22.3% on a market price basis in 2016, ahead of both of its unleveraged benchmarks: the small-cap Russell 2000 Index was up 21.3% while the Russell Microcap Index increased 20.4% for the same period. We were very pleased with the Fund's results on both an absolute and relative basis, particularly in a year in which small-cap stocks held a slight edge over their micro-cap siblings.

RMT's multi-strategy core approach was well-positioned for a market that rewarded factors such as low valuation, liquidity, low volatility, and quality, all of which outperformed within the Russell 2000 and provided some validation for our approach.

The two halves of 2016 were mirror images of one another. The first was stronger on a relative basis while the second was better on an absolute scale. During the first half of 2016, the Fund was up 5.4% on an NAV basis (and 5.8% on a relative basis) versus a gain of 2.2% for the Russell 2000 and a decline of 1.7% for the Russell Microcap for the same period. In the second half, RMT increased 15.7% on an NAV basis and 15.6% based on market price basis. This compared to respective gains of 18.7% and 22.4% for the small-cap and micro-cap indexes.

On an NAV basis, RMT outpaced the Russell Microcap for the one-, 10-, and 15-year periods ended December 31, 2016 while also beating the Russell 2000 for the one-, 15-, 20-year, and since inception (12/14/93) periods. (Returns for the Russell Microcap Index only go back to 2000.) RMT's average annual NAV total return for the since inception period ended December 31, 2016 was 10.8%.

What Worked... And What Didn't

Each of the portfolio's 11 equity sectors made a contribution to calendar-year results. The largest positive impact by far came from Information Technology and Industrials, RMT's two largest sectors, followed by noteworthy net gains from Materials and Financials. Some of the smallest contributions came from those sectors with the smallest weightings: Real Estate, Consumer Staples, Telecommunication Services, and Utilities.

At the industry level, the top-contributors by a sizable margin were electronic equipment, instruments & components (Information Technology), metals & mining (Materials), and machinery (Industrials). Detractors made a very modest negative impact, led by software (Information Technology), distributors (Consumer Discretionary), and IT services (Information Technology).

We are grateful to have been able to deliver such strong absolute and relative results for our investors and firmly believe that we have turned the page on the anomalous 2011-2015 period, in which extraordinary monetary accommodations caused financial markets to behave in odd and unprecedented ways. In our view, we are on the road back to a more historically normal market environment. We think this bodes well for micro-cap and small-cap stocks.

RMT's top-contributing position was IES Holdings, which provides electrical contracting and maintenance services to the commercial, industrial, residential, and power line markets. The firm also engages in data communication services, including the installation of fiber optic telecommunications systems. Very healthy earnings and a strong outlook, both of which were boosted by five acquisitions the firm made between mid-2015 and the end of 2016, attracted investors.

Top-five position Major Drilling Group International performs contract drilling for companies involved in mining and mineral exploration. In a challenging environment for miners early in 2016, the company was able to increase revenues and margins. Revenue growth continued throughout the year as business conditions, while remaining competitive, began to improve. Newport Corporation is a photonics technology specialist whose shares climbed in February after the company agreed to be acquired by MKS Instruments.

As for those holdings that detracted from performance, we held the bulk of our position in ZAIS Group Holdings, an investment manager focused on specialized credit strategies—an asset management segment with what we think is ample long-term potential. Its shares fell with a quarterly loss reported in March and were mostly down through the end of June. A falling stock price in the first half and our confidence in its long-term prospects led us to add shares of Fenix Parts, which recycles and resells original equipment manufacturer automotive parts and products. Consecutive quarterly losses drove investors away before its shares rallied a bit only to fall again when accounting and regulatory issues surfaced. However, we like its core business and were hopeful that the company could resolve these issues in 2017.

Relative to the Russell 2000, the Fund derived the bulk of its advantage from savvy stock selection in Health Care, the only sector in the Russell 2000 with a negative return in 2016. Stock picking offered a more modest advantage in Information Technology. Conversely, our underweight in banks and ineffective stock picks caused Financials to lag, as did poor stock selection in Consumer Discretionary.


Top Contributors to Performance
For 2016 (%)1

IES Holdings 0.88
Major Drilling Group International 0.68
Newport Corporation 0.57
Era Group 0.47
Surmodics 0.47
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

ZAIS Group Holdings Cl. A -0.71
Fenix Parts -0.52
SeaChange International -0.43
Sangamo BioSciences -0.39
Zealand Pharma -0.37
2 Net of dividends

Current Positioning and Outlook

We are grateful to have been able to deliver such strong absolute and relative results for our investors and firmly believe that we have turned the page on the anomalous 2011-2015 period, in which extraordinary monetary accommodations caused financial markets to behave in odd and unprecedented ways. In our view, we are on the road back to a more historically normal market environment. We think this bodes well for micro-cap and small-cap stocks. In our view cyclicals look well-positioned for ongoing leadership. In addition to our usual cyclical tilt, we are looking in some defensive areas such as healthcare. It is very much on a stock-by-stock basis, with a focus on individual companies that combine attractive valuations with strong fundamentals.

Average Annual Total Returns Through 12/31/16 (%)

  QTR* 1 YR 3 YR 5 YR 10 YR SINCE INCEPT. DATE
Royce Micro-Cap Trust NAV 6.71 21.98 3.70 13.59 6.07 10.81 12/14/1993
Russell 2000 8.83 21.31 6.74 14.46 7.07 N/A 12/29/1978

* Not Annualized

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, net of the Fund's investment advisory fee, and reflects the reinvestment of distributions. Past performance is no guarantee of future results Current performance may be higher or lower than performance quoted. Returns as of the recent month-end may be obtained at www.roycefunds.com. The market price of the Fund's shares will fluctuate, so that shares may be worth more or less than their original cost when sold.

The Fund normally invests in micro-cap companies, which may involve considerably more risk than investing in larger-cap companies. The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.

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

Important Performance, Expense, and Disclosure Information

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 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 December 31, 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. 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.

As of 12/31/16, IES Holdings was 1.2% of the Fund's net assets, Major Drilling Group International was 1.0%, Newport Corporation was 0.0%, Era Group was 1.4%, Surmodics was 0.9%, ZAIS Group Holdings Cl. A was 0.1%, Fenix Parts was 0.3%, SeaChange International was 0.2%, Sangamo BioSciences was 0.2%, and Zealand Pharma was 0.8%.

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. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" 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 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. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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