Fund name: Royce Heritage (RGFAX)

Objective: The fund seeks capital appreciation by investing primarily in a portfolio of small- and micro-cap stocks, though it will hold appreciated stocks in the mid-cap range. They use a purely bottom-up process that looks for undervalued stocks by focusing on balance sheet quality and cash flow. "Small-cap" is defined as a market cap under $2.5 billion. The fund can hold foreign securities, but those seem rare. The fund has been broadly diversified and relatively tax efficient.

Adviser: Royce and Associates, LLC. Royce runs a large variety of small-cap value funds, though it has lately been adding other sorts of value (dividend value, tech value, international value) to the mix. In all, it oversees 20 funds with about $25 billion in assets. That amount has increased about five-fold in five years.

Manager: Charles M. Royce, the firm’s founder and chief investment officer. The Royce Funds prospectus shows that Mr. Royce manages six other funds: Pennsylvania Mutual, Premier, Total Return, 100, Financial Services and Dividend Value.

Inception: December 27, 1995.

Minimum investment: $2,000 for regular accounts, $1000 for IRAs.

Expense ratio: 1.49% on an asset base of about $79 million (as of 9/30/06).

Comments: Royce Heritage was established as a niche fund working on behalf of trusteeships, endowments and so on. Investors in the fund were required to lock their funds up for long periods, typically a decade or more. This arrangement benefited the management by providing a pool of captive capital. They could, as a result, make investments that carried substantial short-term risk, without fearing the investors would redeem shares and force the managers to switch strategies.

That strategy apparently worked better for investors than for management: the fund posted consistently excellent returns, but drew little investor interest. The fund’s long-term returns were in the top 1% of all small-blend funds over the past decade; it has averaged 18.4% per year, besting the S&P 500 by about 10% per year and the Russell 2000 by about 8.5%. It has had one down year and seven years of returns over 20%. That’s especially impressive since the manager seems to stress risk management. The fund has outperformed the Russell in 11 of 16 down quarters and seven of eight down markets.

Unfortunately, from the management’s perspective, not enough people were interested. After five years of operation, it had accumulated just $20 million in assets and fewer than $60 million after a decade as one of the industry’s top small cap funds. One presumes that contributed to management’s decision to change the fund’s structure to a more conventional, open-end format.

For investors seeking a small small-cap fund with experienced management and a great track record, this seems like a real no-brainer. For those who suspect that sure things are rarely sure, here are a couple caveats:

1. The change in the fund’s structure may adversely affect performance. Mr. Royce no longer has the luxury of captive capital and may lose some of the freedom that came with it.



2. The change may also engender sudden inflows that will disrupt its performance. The Royce folks don’t shy away from very large small cap funds; five of their funds are larger than $2 billion in assets and the largest is around $6 billion. The firm’s total assets under management are up 500% since 2002. While those funds have generally continued to perform solidly, it will certainly be more difficult to achieve the eye-popping returns of the past decade.



3. Finally, at some point Mr. Royce might become distracted. The firm’s two new international offerings are both set to be managed by Mr. Royce, which means he’ll be responsible for nine different funds with a fair value of focuses (domestic small value, financials, international).

Bottom line: This isn’t a sure thing, but certainly a reasonable bet. Mr. Royce is unquestionably talented and the fund has an undeniably excellent pedigree. If you like the Royce style, this is as good a place as any to access it.

Company link:Royce Funds



January 1, 2007