Chuck Royce: Risk, Volatility, and Royce Total Return Fund by The Royce Funds

At Royce, we manage risk by embracing volatility and evaluating companies we believe to be undervalued—one of the keys to outperformance for active managers such as ourselves. In this piece we examine the role that volatility has played in the Fund’s performance history, which goes back to December 1993.

Financial Professionals can log in to see the full piece, including the Fund’s down market performance, standard deviations, and downside capture versus the Morningstar Small Blend Category. The expanded piece also shows the Fund’s historical risk-adjusted performance record (as measured by the Sharpe ratio) against the Russell 2000 and the Morningstar Small Blend category average.

In many ways, Royce Total Return Fund was designed to seek better downside protection and risk-adjusted returns.

The broadly diversified portfolio of dividend-paying small-cap stocks was meant to attempt to provide a potential cushion against the extremes of market volatility, particularly when markets were correcting. We seek to meet these goals by investing in companies that possess strong balance sheets, solid fundamentals and what we think are attractive valuations.

We are pleased that these goals have largely been met since the Fund’s inception on 12/15/93. Total Return beat its small-cap benchmark, the Russell 2000 Index, in all 11 down markets over the past 15 years (see the graph below).

Down Market Performance Comparison (%)


We are also pleased with the Fund’s long-term record in more volatile markets. Before examining Total Return’s historical results, it’s worth pointing out that at Royce we view volatility as an ally. We agree with Warren Buffett, who once said, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

So while many investors think of volatility as synonymous (or nearly so) with risk, we take a different view. Rather than avoid volatility, we see the challenge of managing risk as trying to take advantage of the market’s movements—an essential skill for any successful active manager.

Those times when the market cannot seem to make up its mind are exactly when securities tend to be most attractively mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities.

While volatility typically signals a downward shift in returns, our recent research found that outperformance for active managers has not been limited to flat or down market periods.

This study used standard deviation to measure volatility and looked at monthly rolling 36- and 60-month standard deviations from the Fund’s first full month of performance (that is, starting from 12/31/93) through 12/31/14. This gave us a large number of data points spanning more than 20 years—217 for the 36-month period and 193 for the 60-month period. We then sorted the annual standard deviations from highest to lowest and divided them into quintiles.

Volatility and Small-Cap Performance Spreads (%)

From 12/31/93 through 12/31/14

Average of 36-Month Monthly Rolling Statistics
Average Russell 2000 Standard Deviation 13.44 16.78 20.46 23.05 26.03
Average Russell 2000 Performance 14.37 16.31 8.71 5.13 0.16
Average Total Return Performance 16.05 15.36 10.90 9.95 3.98
Average Total Return Spread vs Russell 2000 1.68 -0.95 2.18 4.82 3.82
Average of 60-Month Monthly Rolling Statistics
Average Russell 2000 Standard Deviation 16.17 19.04 21.26 22.57 24.27
Average Russell 2000 Performance 12.99 11.65 6.26 5.96 2.19
Average Total Return Performance 13.90 12.77 9.74 10.03 5.10
Average Total Return Spread vs Russell 2000 0.92 1.12 3.48 4.06 2.91

We found that the Fund had a mixed but mostly positive record versus the benchmark during periods of lower volatility—that is Quintiles 1 and 2 for both the 36- and 60-month periods shown above. However, as volatility increased, we saw a more pronounced and consistent performance advantage for Total Return, which enjoyed its widest outperformance spreads in Quintiles 3, 4, and 5 of volatility.

It’s important to note that this is a correlation—we are not suggesting that volatile markets caused the Fund to do better, only that an examination of history reveals this correlation. Equally important, these results are consistent with how we have sought to manage the Fund throughout its more than 20 years of history.

Royce Total Return Fund [RYTRX]

Average Annual Total Returns Through 12/31/14 (%)

Total Return 1.34 15.47 13.32 7.50 10.12 11.55 11.21 12/15/1993
Russell 2000 4.89 19.21 15.55 7.77 7.38 9.63 9.22 N/A
Annual Operating Expenses: 1.18%