FTF Royce US Smaller Companies: October 2021 fund update

• The fund is managed by Lauren Romeo, who is supported by a highly experienced team at Royce with support from Franklin Templeton
• Romeo invests in her own fund and is rewarded based on its long-term performance, aligning her interests with investors
• The fund offers a differentiated approach to a lot of other US equity funds which means it has the potential to perform quite differently
• This fund is on our Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits in a portfolio

The FTF Royce US Smaller Companies fund aims to deliver long-term growth by investing in unloved US smaller companies, with the potential to come back into favour or recover in future. It could be a good way to add US exposure to a global portfolio, or work well alongside other US funds focused on larger, more growth-style companies. Smaller businesses are often among the most innovative and offer lots of growth potential, but they're higher risk than their larger counterparts.

Manager

The fund is managed by Lauren Romeo, who joined Royce and Associates in 2004. She started out as assistant manager of the fund, before being appointed co-manager in 2010 and lead manager in 2011. We like the Royce team’s disciplined approach and think Romeo is an engaging and experienced fund manager with a passion for investing in smaller companies. Romeo is supported by a team with bags of experience, including the firm’s founder Chuck Royce who has been investing client money since 1972. We believe that the fund harnesses the skills of a talented team with a sensible investment approach. Romeo is also named as co-manager on some other funds in the US that invest with a similar philosophy as this fund. We’re satisfied that these responsibilities are manageable.

Process

Romeo aims to invest in companies that are unpopular with investors and buy their shares at a price significantly lower than she feels they’re worth. They might be facing headwinds in the shorter term, so it's important they don't have too much debt. Romeo and her team spend a lot of time meeting with a company's managers to make sure they've got the skill and experience to turn the business around. They also speak to customers, suppliers and competitors to make sure the managers are executing their plan.

This analysis leads Romeo’s team to decide what they think a company's shares are worth. She thinks this process provides opportunities to spot companies that are undervalued. This could also provide some support when markets are weaker – if a company's share price is already lower than it should be, it might not fall quite so far as those that are more expensive. They won't get it right every time though and even when they do, it can take some time for other investors to realise the opportunity and to see the share price rise. This means there will be periods where the fund underperforms and seems at odds with the wider market, so this style of investing requires patience.

Romeo thinks this is an exciting time to be investing in US smaller companies on the basis of more reasonable valuations compared to larger companies as well as a more favourable earnings outlook.

The fund maintains a significant focus towards the Industrials sector with 32.2% of the fund invested there. In recent months Romeo has added to existing holdings in the sector following share price declines but also added a new position in Great Lakes Dredge and Dock. The company is the largest US provider of dredging services with a market share around 38%. Romeo believes the company’s cost advantage over peers, strong balance sheet and large and diverse fleet leave it well positioned to deliver growth.

In contrast, consumer staples exposure was reduced. Romeo exited the fund’s investment in Central Garden and Pet on valuation grounds with the share price having risen 36% since she bought the position. She also sold an investment in confectioner, Tootsie Roll. Romeo lost conviction in the management’s ability to capitalise on the opportunities present for product innovation and margin expansion and preferred to reallocate the money invested.

Culture

Smaller-company value investing is Royce's specialism – it’s what they do and is where their expertise lies. This single focus distinguishes the firm from other asset managers in the US. Fund managers at Royce are required to invest substantial amounts in the funds they run and have variable bonuses based on the long-term performance of their funds. We feel this is a positive and ensures alignment with the interests of investors.

Franklin Templeton last year acquired Legg Mason Asset Management, which means this Royce fund fund now sits under the Franklin Templeton umbrella. The fund subsequently rebranded from Legg Mason Royce US Smaller Companies to FTF Royce US Smaller Companies. This is just a name change though. The fund’s investment philosophy and process remains the same and Romeo retains autonomy over the fund.

Romeo considers ESG (Environmental, Social and Governance) issues when researching individual companies. She thinks these factors have the potential to affect the long term value of the investment and thinks sound understanding of how these factors could affect businesses is an important part of managing risk in the fund.

Cost

The fund has an ongoing annual charge of 0.86%, but we’ve secured HL clients an ongoing saving of 0.33%. This means you’ll pay a net ongoing charge of 0.53%. The fund discount is achieved through a loyalty bonus, which could be subject to tax if held outside an ISA or SIPP. The HL platform fee of up to 0.45% per year also applies.

Performance

The fund’s made attractive returns since Romeo became a co-manager in 2010 but hasn’t managed to keep up with the broader US market of smaller companies. This is disappointing and we would have expected the fund to perform better given the manager’s bias towards higher-quality smaller companies. But many of the companies the manager favours have remained undervalued and out of favour, holding back returns.

Over the past year the fund has performed similarly to the Russell 2000, delivering a return of 41.0%, 0.6%* behind the benchmark. At the sector level the fund’s investments in the Technology and Health Care sectors have aided performance the most. Meanwhile Romeo’s allocation to Industrials and Consumer Discretionary stocks have been the most painful.

Our analysis suggests that the fund’s investments in Century Casinos and the people and organizational advisory company Korn Ferry have been among the most important contributors to performance. Weaker performers included health care company Simulations, hair salon company Regis Corp and semiconductor supplier CMC Materials.

We believe a well-diversified portfolio should have exposure to a mixture of different investment styles, asset classes and geographies, and we think this fund offers something quite different. Past performance isn’t a guide to the future.

Annual percentage growth

Past performance isn't a guide to the future. Source: *Lipper IM to 30/09/2021.

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