article 05-02-2016

Risk, Volatility, and Royce Total Return Fund

At Royce, we manage risk by embracing volatility and evaluating companies we believe to be undervalued—one of the keys to outperformance for active managers such as ourselves. In this piece we examine the role that volatility has played in the Fund's performance history, which goes back to December 1993.

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In many ways, Royce Total Return Fund was designed to seek better downside protection and risk-adjusted returns.

The broadly diversified portfolio of dividend-paying small-cap stocks has always been built in an attempt to provide a potential cushion against the extremes of market volatility, particularly when markets were correcting. We seek to meet these goals by investing in companies that possess strong balance sheets, solid fundamentals, and what we think are attractive valuations.

We are pleased that these goals have largely been met since the Fund's inception on 12/15/93. Total Retun beat both its small-cap benchmark, the Russell 2000 Index, and its peer average in the Morningstar U.S. Small Blend Category in all 11 downturns of 7.5% or more over the past 15 years.

Down Market Performance Comparison and Morningstar Small Blend Category Average (%)1 Through 3/31/16

Enlarge

1 565 US Small Blend Funds tracked by Morningstar with at least five years of history as of 3/31/16.

The Fund also boasted better downside capture than the Morningstar U.S. Small Blend Category Average. Better down market results have been critical to delivering consistently attractive risk-adjusted returns. For example, in 97% of the rolling five-year periods over the past 15 years, the Fund beat its Small Blend peers on a risk-adjusted return basis, as measured by Sharpe ratio.

Downside Capture vs. Russell 2000 (%)
From Royce Total Return Fund's First Full Quarter (12/31/93) Through 3/31/16

Royce Total Return Fund Sharpe Ratio Results (%)
% of 5-Year Monthly Rolling Sharpe Ratios Over the Last 15 Years (12/31/00-3/31/16) That:

2 1,491 US Small-Cap Funds and 565 Small Blend Funds tracked by Morningstar with at least five years of history as of 3/31/16.

We are also pleased with the Fund's long-term record in more volatile markets. Before examining Total Return's historical results, it's worth pointing out that at Royce we view volatility as an ally when selecting stocks. We agree with Warren Buffett, who once said, "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

So while many investors think of volatility as synonymous (or nearly so) with risk, we take a different view. Rather than avoid volatility, we see the challenge of managing risk as trying to take advantage of the market's movements—an essential skill for any successful active manager.

Those times when the market cannot seem to make up its mind are exactly when securities tend to be most attractively mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities.

While volatility typically signals a downward shift in returns, our recent research found that outperformance for active managers has not been limited to flat or down market periods.

We saw the potential for better downside protection by using a disciplined, value-based approach to invest in dividend-paying small-caps. Needless to say, we are very pleased that history has supported the effectiveness of this strategy.

This study used standard deviation to measure volatility and looked at monthly five-year standard deviations from Total Return's first full month of performance (that is, starting from 12/31/93) through 3/31/16. This gave us a large number of data points spanning more than 20 years—208 for the five-year period. We then sorted the annual standard deviations from highest to lowest and divided them into quintiles. For each monthly rolling period in each quintile we looked at the corresponding outperformance of the Fund and the Morningstar U.S. Small Blend Category Average versus the Russell 2000. The results are in the following table:

Volatility and Small-Cap Performance Spreads (%)
From 12/31/93 through 3/31/16

QUINTILE 1 QUINTILE 2 QUINTILE 3 QUINTILE 4 QUINTILE 5
Average of 5-Year Monthly Rolling Statistics
Average Russell 2000 Standard Deviation 15.99 18.38 20.91 22.44 24.18
Average Russell 2000 Performance 12.53 12.90 7.05 6.10 2.18
Average Morningstar Small Blend Category Performance 12.38 13.23 8.80 8.81 2.92
Average Morningstar Small Blend Category
Performance Spread1 vs Russell 2000
-0.14 0.33 1.75 2.71 0.74
Average Total Return Performance 12.39 13.30 10.28 10.60 4.96
Average Total Return Spread vs Russell 2000 -0.13 0.40 3.23 4.50 2.78

1 Average of all funds in the US Open End Small Blend Category tracked by Morningstar with at least 12 months of history as of the relevant month end. Source: Morningstar Direct

We found that, on average, active management (including Total Return) had a mixed but mostly positive record versus the Russell 2000 during periods of lower volatility. The average standard deviations for the Russell 2000 in the lowest quintile of volatility was 15.99%. During the five-year period, Total Return outpaced the benchmark, though the respective performance spreads were comparatively narrow.

As volatility increased, we saw a more pronounced performance advantage for Total Return. The Fund enjoyed its widest outperformance spreads in Quintiles 3, 4, and 5 of volatility. In these periods Total Return had sizable advantages over both its benchmark and its peers in the Morningstar U.S. Small Blend Category.

It's important to note that this is a correlation—we are not suggesting that volatile markets caused the Fund, or active management more generally, to do better, only that an examination of history reveals this correlation.

It's also worth pointing out that for most of the last five-plus years, volatility fell and remained low. This created a more challenging environment for active managers. However, this has begun to change, in particular for small-cap stocks, which have been growing steadily more volatile since the second quarter of 2014. We think that this should ultimately bode well for risk-conscious active small-cap managers.

Equally important is that all of these results are consistent with how we have sought to manage the Fund throughout its more than 20 years of history. We saw the potential for better downside protection by using a disciplined, value-based approach to invest in dividend-paying small-caps. Needless to say, we are very pleased that history has supported the effectiveness of this strategy.

Royce Total Return Fund [RYTRX]
Average Annual Total Returns Through 3/31/16 (%)

QTR* 1 YR 3 YR 5 YR 10 YR 15 YR 20 YR SINCE INCEPT. DATE
Total Return 5.17 -4.09 5.88 6.80 5.44 8.56 9.84 10.43 12/15/93
Russell 2000 -1.52 -9.76 6.84 7.20 5.26 7.56 7.68 8.39 N/A
Annual Operating Expenses: 1.19%
* Not Annualized

Important Performance and Expense Information

All performance information 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. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus dated 5/1/15 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.

Financial Professionals can log in to see the full piece, including the Fund's down market performance, standard deviations, and downside capture versus the Morningstar Small Blend Category. The expanded piece also shows the Fund’s historical risk-adjusted performance record (as measured by the Sharpe ratio) against the Russell 2000 and the Morningstar Small Blend Category Average.

In many ways, Royce Total Return Fund was designed to seek better downside protection and risk-adjusted returns.

The broadly diversified portfolio of dividend-paying small-cap stocks has always been built in an attempt to provide a potential cushion against the extremes of market volatility, particularly when markets were correcting. We seek to meet these goals by investing in companies that possess strong balance sheets, solid fundamentals, and what we think are attractive valuations.

We are pleased that these goals have largely been met since the Fund's inception on 12/15/93. Total Return beat its small-cap benchmark, the Russell 2000 Index, and its peer average in the Morningstar U.S. Small Blend Category in all 11 downturns of 7.5% or more over the past 15 years.

Down Market Performance Comparison (%)

Enlarge

We are also pleased with the Fund’s long-term record in more volatile markets. Before examining Total Return's historical results, it’s worth pointing out that at Royce we view volatility as an ally when selecting stocks. We agree with Warren Buffett, who once said, "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

So while many investors think of volatility as synonymous (or nearly so) with risk, we take a different view. Rather than avoid volatility, we see the challenge of managing risk as trying to take advantage of the market’s movements—an essential skill for any successful active manager.

Those times when the market cannot seem to make up its mind are exactly when securities tend to be most attractively mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities.

While volatility typically signals a downward shift in returns, our recent research found that outperformance for active managers has not been limited to flat or down market periods.

We saw the potential for better downside protection by using a disciplined, value-based approach to invest in dividend-paying small-caps. Needless to say, we are very pleased that history has supported the effectiveness of this strategy.

This study used standard deviation to measure volatility and looked at monthly five-year standard deviations from Total Return's first full month of performance (that is, starting from 12/31/93) through 3/31/16. This gave us a large number of data points spanning more than 20 years—208 for the five-year period. We then sorted the annual standard deviations from highest to lowest and divided them into quintiles.

Volatility and Small-Cap Performance Spreads (%)
From 12/31/93 through 3/31/16

QUINTILE 1 QUINTILE 2 QUINTILE 3 QUINTILE 4 QUINTILE 5
Average of 5-Year Monthly Rolling Statistics
Average Russell 2000 Standard Deviation 15.99 18.38 20.91 22.44 24.18
Average Russell 2000 Performance 12.53 12.90 7.05 6.10 2.18
Average Morningstar Small Blend Category Performance 12.38 13.23 8.80 8.81 2.92
Average Morningstar Small Blend Category
Performance Spread1 vs Russell 2000
-0.14 0.33 1.75 2.71 0.74
Average Total Return Performance 12.39 13.30 10.28 10.60 4.96
Average Total Return Spread vs Russell 2000 -0.13 0.40 3.23 4.50 2.78

1 Average of all funds in the US Open End Small Blend Category tracked by Morningstar with at least 12 months of history as of the relevant month end. Source: Morningstar Direct

We found that, on average, active management (including Total Return) had a mixed but mostly positive record versus the Russell 2000 during periods of lower volatility. The average standard deviation for the Russell 2000 in the lowest quintile of volatility was 15.99%. During the five-year period, Total Return outpaced the benchmark, though the respective performance spreads were comparatively narrow.

It's important to note that this is a correlation—we are not suggesting that volatile markets caused the Fund, or active management more generally, to do better, only that an examination of history reveals this correlation. Equally important is that all of these results are consistent with how we have sought to manage the Fund throughout its more than 20 years of history. We saw the potential for better downside protection by using a disciplined, value-based approach to invest in dividend-paying small-caps. Needless to say, we are very pleased that history has supported the effectiveness of this strategy.

Royce Total Return Fund [RYTRX]
Average Annual Total Returns Through 3/31/16 (%)

QTR* 1 YR 3 YR 5 YR 10 YR 15 YR 20 YR SINCE INCEPT. DATE
Total Return 5.17 -4.09 5.88 6.80 5.44 8.56 9.84 10.43 12/15/93
Russell 2000 -1.52 -9.76 6.84 7.20 5.26 7.56 7.68 8.39 N/A
Annual Operating Expenses: 1.19%
* Not Annualized

Important Performance and Expense Information

All performance information 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. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus dated 5/1/15 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.

Important Disclosure Information

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.) The Sharpe Ratio is calculated for a specified period by dividing a fund’s annualized excess returns by its annualized standard deviation. The higher the Sharpe Ratio, the better the fund’s historical risk-adjusted performance. Standard deviation is a statistical measure within which a fund’s total returns have varied over time. The greater the standard deviation, the greater a fund’s volatility. Please read the prospectus for a more complete discussion of risk. 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. Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. 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.

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