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How a Fund Boutique Grew Without Losing Its Soul

Royce has gotten bigger without giving up its autonomy.

Karin Anderson, 12/02/2010

Over the course of nearly four decades, Royce & Associates has demonstrated sound leadership in small-cap investing. The firm nurtures an atmosphere that encourages individuality and collaboration at the same time--while also growing the firm in terms of assets, funds, and portfolio managers.

Since 1972, when Chuck Royce first began managing flagship Royce Pennsylvania Mutual Fund PENNX, Royce & Associates has grown to offer 26 funds--many of them beyond the firm's small-cap core--and employs 38 investment professionals. Royce managed $29 billion in assets on Dec. 31, 2009.

The Royce team has been successful at hiring midcareer professionals, and the average investment-industry experience on the team is 24 years. The firm's most-senior managers, including Chuck Royce, Whitney George, Charlie Dreifus, and Buzz Zaino, have managed funds for 38 years on average--20 of them at Royce. The newer managers have more than 15 years of experience.

Recent hires include Carl Brown, Brendan Hartman, and Jim Stoeffel, formerly of Cramer Rosenthal McGlynn, in 2008. More recently, George Wyper, formerly of Wyper Capital Management, joined Royce with two analysts and a few accounts in tow. He continues to run money from his former firm and joined Whitney George on Royce Focus Value RYFVX.

Nurturing Management Talent
That said, new team members don't typically dive into portfolio-management roles right away. Jenifer Taylor, for example, joined the firm in 2000 as an analyst and worked with George for several years on Royce Micro Cap RYOTX before becoming comanager. Similarly, Jay Kaplan, who had managed money previously at Prudential Financial PRU, spent his first six months at Royce performing a variety of research projects before becoming a comanager on Royce Value RYVFX.

Overall, Royce has grown its staff with investors experienced in analyzing and investing in smaller companies, and has taken the time to introduce the firm's beliefs and culture before giving them money to run under the Royce banner. The firm has also done a good job of retaining its personnel--a sign of a strong culture. Its five-year annualized manager-retention rate clocked in at 96% at the end of 2009, which was high relative to the industry norm.

All the while, Chuck Royce has remained the firm's leader and engaged in portfolio management, giving rise to key-man risk. The succession plan, though, has become clearer recently: Whitney George was promoted to co-chief investment officer in 2009, and for now he serves alongside Chuck Royce. Testament to the firm's long-term orientation, planning for this transition has taken place well in advance of Chuck Royce's retirement. Whitney George is no second fiddle, though: His is named as a portfolio manager or comanager on 12 of Royce's funds and was Royce's first champion of small-cap industrials. He has thus made his mark on many of Royce's portfolios.PAGEBREAK

In addition to high manager-retention rates, the firm's corporate culture is strong in other ways. Although each manager adheres generally to a small-cap value philosophy, variations on the style are encouraged given each manager's passion and area of expertise. For example, Dreifus, of Royce Special Equity RYSEX is an accounting maven with a keen focus on downside risk. He acknowledges that the risks he takes "are like jumping off a pancake." On the other hand, Buzz Zaino of Royce Opportunity RYPNX has an affinity for turnaround stories, undervalued asset plays, and busted IPOs in the micro-cap universe, which has made for a much wilder ride. All of the managers have made sizable investments in the funds they run, aligning their own interests with those of fundholders.

The firm's shareholder communications, whether through its website, newsletters, or annual reports, are topnotch. They stress long-term performance and generally do an excellent job of explaining why managers like or dislike particular securities, what securities they've been buying or selling, which holdings have helped or hurt performance, and how management's macroeconomic views can influence portfolio construction. The funds' overall investor returns, which approximate how the average investor in the funds has performed taking into account fund flows, have shown that fundholders have used the offerings well--suggesting that Royce has done a good job of educating its shareholder base.

Particularly among small-cap funds, several of the Royce funds are big, so they can hardly be called nimble. But Royce does have a reasonable, shareholder-focused philosophy when it comes to fund closings. Specifically, it has closed funds when it thinks "hot money" is coming in the doors. This tends to happen as the funds, or small-cap stocks in general, have performed well, and Royce worries about performance-chasers and new shareholders at a time when good values may be harder to find. Currently, doors are closed to new investors at Royce Premier RYPRX and Royce Micro-Cap, and Dreifus is likely push for Royce Special Equity's doors to close again if he concludes that money is coming in too quickly and he lacks sufficient investment ideas.

Although Royce's fund lineup has nearly tripled during the past decade, trendy fund launches haven't been a concern. The people hired and expertise brought in have tended to drive fund launches, so that growth makes sense, given that Royce has acquired expertise in the foreign and mid-cap arenas. However, the firm's central investment philosophy leads to some overlap among offerings with similar strategies, such as mid-blend funds Royce Premier and Royce SMid-Cap Value RMVSX, and small-blend funds Royce Total Return RYTRX and Royce Dividend Value RYDVX. This can make it difficult for an investor to choose among clusters of similar funds that the firm groups by market-capitalization range, portfolio diversification, and volatility.

The distinctive and enduring small-cap culture at Royce is particularly impressive considering it has been part of a larger organization, Legg Mason LM, since 2001 (when Chuck Royce sold the firm). In addition to Royce, Legg Mason owns a diverse group of asset managers that includes Legg Mason Capital Management, Western Asset, and ClearBridge. Because Legg Mason is a publicly traded firm, there is potentially more risk of conflicts of interests arising between Legg Mason's stockholders and Royce fundholders. Stockholders typically want higher fees and asset levels, and thus higher revenues, whereas fund investors desire low fees and strong fund performance. To that end, Legg Mason chairman and CEO Mark Fetting has been on Royce's board of directors since 2001, and the fees have generally been above average across the Royce lineup.

That said, Chuck Royce sold his firm to Legg Mason with the belief that the new owners would allow it broad autonomy, which included retaining a no-load platform. For the most part, Legg Mason has indeed been hands-off, and thus this particular owner/subsidiary relationship should be counted as an overall success.

Karin Anderson is a mutual fund analyst with Morningstar.

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