Royce Funds Commentary: A Shift to Small-Cap Value

Q&A with Chris Clark and Francis Gannon

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Apr 08, 2016
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Royce's Co-CIOs, President Chris Clark and Managing Director Francis Gannondiscuss The Royce Funds' recent performance turnaround and how we are fully committed to ensuring that Royce remains preeminent in the small-cap space.

Royce's Co-CIOs, President Chris Clark and Managing Director Francis Gannon respond to questions from clients about many Royce Funds' recent performance turnaround.

Francis Gannon: In a number of recent client meetings, we were asked about the turnaround in many of our Funds' returns.

Wanting to understand the factors leading to these strong results, our clients were also curious about whether we expect this shift to be long lasting. It's clear why they asked.

As you can see from the bar graph, most of our domestic small-cap funds, specifically those that use the Russell 2000 Index as a benchmark, outperformed the small-cap index during 1Q16, some very significantly.

Royce Funds Gain Momentum YTD
YTD Performance1 of U.S. Small-Cap Royce Funds2 vs Russell 2000 through 3/31/16 (%)

Chris Clark: Certain market movements keyed the reversal as did moves that we made internally.

The market only recently began to reward profitability and recognize how low valuations had become outside the narrow areas that worked in 2015. Our strategies lean to varying degrees towards value, quality, and/or cyclical companies.

Until this year, these factors were distinctly out of favor. Investors preferred fast-growing, higher leverage, non-earning, and/or non-cyclical companies, most notably in biotech.

For many reasons, we believe that all of these trends have reversed, and that the countermove, which we expect to be long lasting, will be favorable to the way that many of our managers invest.

However, this change did not suddenly occur during the last three months; it started when the Russell 2000 reached a peak last summer.

You can see that in the market cycle table, where once again most of our domestic small-cap funds outperformed the Russell 2000 handily from the small-cap peak on 6/23/15 through 3/31/16. This table also shows how anomalous the last cycle was for many Royce Funds. History shows that, though we typically outperform over full market cycles, we did not in the last cycle.

Francis: This shift is also about the steps we took to streamline our offerings—we rationalized our portfolio line-up, going from 28 open-end funds to 18 over the last two years.

I think that's why the most recent cycle looks more like some of the previous market cycle periods in which we generally outperformed. This is one of our goals—to give investors strong absolute and relative results over full market cycles.

Royce Outperformance is Strong in the Current Market Cycle
Market Cycle1 Results from U.S. Small-Cap Royce Funds2 vs Russell 2000

Chris: So while the shift in small-cap stretches back more than nine months, our internal effort began two years ago when we started working to create more meaningful differentiation among our portfolios and to provide our portfolio managers with even more quantitative resources.

Our Fund Framework offers one way to see the fruit of these efforts, though the recent market cycle and first-quarter returns might offer an equally significant demonstration.

Francis: I think everyone feels like a lot of the hard work we've been doing has begun paying off.

The last few years when most of our approaches were out of favor were very challenging. Of course, we also made our share of mistakes. But we've made important changes.

We added more dedicated analysts and quantitative resources while striving to improve and refine the advantages we already had in place—the best and deepest small-cap research platform in the industry and unmatched access to company managements.

Chris: These moves allow our portfolio managers to execute on a distinct investment discipline within one of our value, core, and/or growth approaches, aligning them with the strategy that works best with their experience. This exclusive focus frees them up to do what they do best.

Francis: We couldn't be happier about the progress we've made—but we fully understand that this is only the beginning of the process.

We are fully committed to ensuring that Royce remains preeminent in the small-cap space.

Our position as independent thinkers with unparalleled knowledge and experience in the small-cap space is something that we take very seriously. We expect a great deal of ourselves and know that our shareholders and clients do as well.

Chris: Absolutely, and we think it's important they know that we saw the recent decline as a strong signal to buy.

The evidence for long-term small-cap strength following bear markets is considerable.

We can't predict future results, but we did see the shift as a major market inflection point in which profitability and low leverage will matter more and more to investors for the next few years, if not longer.

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 at www.roycefunds.com. 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 and other expenses.

Important Disclosure Information

Mr. Clark's and Mr. Gannon's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. 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.)

The 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 index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.