During the course of the past few years, many of our Funds have experienced relative performance challenges. While the same factors that most contributed to our past success—people, process, and performance—will remain the foundation for our success in the future, we are also constantly seeking to improve and have found areas where we needed to make adjustments. We are using those same factors that helped to drive our historical success to guide us as we move forward.
As I look back on my first year as president of Royce, I wanted to discuss with you some of our recent challenges and what I see as our roadmap for future success.
First, I want to address the challenges we have faced in our Funds' investment performance. After several decades of relative outperformance, we find ourselves in the midst of an unprecedented period of underperformance. While we have been satisfied with our absolute returns, we also recognize that they have been generated in an environment in which our benchmarks have done meaningfully better. Some of the relative drag was admittedly self-inflicted—several Funds stayed with sizable overweights in commodity-based businesses well after a lengthy bull cycle for those stocks had run its course. In addition, our recent preference for more economically sensitive businesses has not yet been rewarded during an extended period of uneven global growth.
External factors have also played a role. Fed policies designed to keep the economy and capital markets above water—which included multiple rounds of QE and keeping interest rates at or near zero—had other, unanticipated consequences, especially in the small-cap market. For example, it became both easy and affordable for businesses to add debt, essentially nullifying the risk differential between lower- and higher-quality businesses. Lower-quality and more highly levered companies began a historically atypical period of outperformance in which our Funds did not participate. These actions boosted stock correlations and reduced volatility, making it harder to find the kind of mispriced opportunities that have always been our stock in trade.
Finally, extraordinary outperformance by high-growth, non-earning, and more speculative businesses also created significant headwinds. This continues into the present day, with recentsmall-cap leadership narrowing dangerously to bio-pharma and software & services stocks, a development that represents more of a wager on long-duration growth than current profitability. In both cases, our more valuation sensitive, risk-conscious approaches have generally kept us away from these areas. While we clearly missed some opportunities, we believe these trends will fade and that many of these speculative bubbles will ultimately burst. That said, we also understand the frustrations that have built over the last few years as active managers such as ourselves have struggled.
Recent lagging results have called for a large degree of self-reflection by our entire firm. We concluded that the factors which contributed to our past success—a focus on people, process, and performance—will remain the foundation for our success in the future. Nonetheless, we are also committed to constantly seeking to improve and have found areas where we needed to make adjustments.
People
As I have said in the past, our people are our most crucial asset. We have always sought to hire and develop not just people with intelligence, skill, and dedication, but also those who could thrive in the unique culture that we have created here at Royce. Importantly, we take great pride in being a boutique business and cherish our status as an operationally independent, autonomous small-cap specialist. We believe our boutique culture creates benefits for our investors as it enables us to attract and retain exceptional investment professionals. Today, I believe we have some of the best investment minds in the business, as well as great talent in information technology, sales and client service, and marketing.
Process
Regarding our investment process, we remain committed to being highly active small-cap managers in a world that is increasingly enamored with passive approaches. The micro- and small-cap asset classes continue to offer a broad range of opportunities in which inefficiencies remain abundant. We also remain committed to our disciplined, risk-oriented, and long-term investment approach while fully recognizing that to achieve success over the long term, we must endure and even welcome periods of underperformance. We understand that our strategies will go in and out of favor but also believe strongly that they will prove themselves over full market cycles. Critical thinking and a contrarian orientation remain crucial attributes of our thought process, ensuring that we are always looking in corners of the market that others are neglecting while staying away from more crowded or speculative areas.
Performance
As for delivering performance, we have also comprehensively reviewed our portfolio construction, increasing emphasis on those companies in which our conviction was highest while selling or reducing those in which it had waned. In some Funds this has resulted in paring back the number of holdings and/or increasing position sizes. Comprehensive portfolio reviews are now an ongoing part of the investment function at the firm and include regular analysis of:
- the factor risks inherent in our bottom-up process,
- the importance of high active share, and
- the consistency of portfolio construction.
To facilitate these efforts, we have recently added analysts and other resources to further ensure that our portfolio managers have all they need to excel. The result is an investment staff that spans multiple generations and includes an enviable combination of new perspectives and seasoned experience.
Future Success
As investors and business managers, we have the wonderful advantage of having seen many companies go through challenging periods. We have observed that those companies which emerge stronger from these periods are those that focus sharply on their core competencies, recommit to what made them distinctive, and address the specific issues that need improvement. Over the past year, we have sought to strike exactly that balance by focusing on those factors which drove our past success while also addressing areas where action was warranted. Balancing a commitment to our core investment principles combined with a relentless focus on constant improvement will drive what we believe will be an exciting and prosperous future for our shareholders.
We greatly appreciate your interest in our work and look forward to continuing to share our perspectives with you as we navigate the wealth of opportunities that lie ahead.
For The Royce Funds' one-, five-, 10-year, and/or since inception returns as of the most recent quarter-end period, please see our Prices and Performance page.
Important Disclosure Information
The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.
This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. The Royce Funds, with the exception of Royce Special Equity Multi-Cap Fund, invests in securities of micro-cap, small-cap, and/or mid-cap stocks, which may involve considerably more risk than investments in securities of larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)
