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The Case for Royce Special Equity

This fund has appeal even if some trailing-return periods are underwhelming.

I recently recommended

Well, to be specific, he asked what I saw in a fund with such lousy five- and 15-year performance. That’s a good question.

Here’s what I see. Lead manager Charlie Dreifus looks for companies with sparkling clean accounting and low debt. Ideally, they’re also trading cheaply. This leads him to some nice, boring little companies that tend to lag in strong rallies but make it up on the downside. Few funds focus as much on accounting issues, and that makes it stand out. The fund’s debt/capital ratio of 17.5 is half that of the small-value Morningstar Category.

In 2008, the fund lost 19.6% when the S&P lost 37%. It gets 5 stars for its 10-year record despite returns that are just modestly above average because its risk was well below average. If you look back to the fund’s inception, so that you are spanning two bear markets, Dreifus put up a return of 9.46% annualized versus 8.3%. When you risk-adjust returns using the Sortino ratio, the fund tops all the other small-value funds we cover with a 0.92 compared with 0.66 for

Another thing I see is the fund’s appeal as a diversifier. Because it is a relatively focused portfolio of clean-accounting small caps, the fund is less like the S&P 500 than most. Its R-squared is just 39 compared with 57 for

I think one of the main reasons to go into small value is to boost diversification, and Royce Special Equity delivers that nicely. I own the fund, so my money is where my mouth is.

Where I Could Be Wrong I see two potential challenges for my bull case. First, the fund's defenses are not as bulletproof as, say, a high-quality short-term bond fund. It's more or less math that such a fund will hold up better when interest rates spike or credit risk strikes. The fund is close to being fully invested (cash stands at 10%), and we know that every bear market is different. Maybe the next one will strike small value harder than anything else and maybe growth will hold up much better, so that the fund's cheap stocks don't offer as much protection. The fund does have an overweighting in consumer cyclicals. It could happen, but I still think it's likely that this fund will outperform in the next bear market anyway.

Another source of concern is that Dreifus is 73. Steven McBoyle was named assistant portfolio manager and is clearly meant to take over when Dreifus steps down. McBoyle has experience. He’s been at Royce since 2007 and was at Lord Abbett before that. He’s well-versed in this fund’s strategy, so I’m confident the process won’t change much. But will McBoyle execute as well as Dreifus? He’s already contributing to the fund today, but we won’t really know until a few years after he’s taken the helm.

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