UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT INVESTMENT
COMPANIES

Investment Company Act file number 811-07288
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
-------------------------------------
(Exact name of registrant as specified in charter)

ONE FRANKLIN PARKWAY, SAN MATEO, CA 94403-1906
(Address of principal executive offices) (Zip code)

MURRAY L. SIMPSON, ONE FRANKLIN PARKWAY, SAN MATEO, CA 94403-1906
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(Name and address of agent for service)

Registrant's telephone number, including area code: 650 312-2000
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Date of fiscal year end: 09/30
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Date of reporting period: 09/30/04
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ITEM 1. REPORTS TO STOCKHOLDERS.

[GRAPHIC OMITTED]

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SEPTEMBER 30, 2004
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ANNUAL REPORT AND SHAREHOLDER LETTER | INCOME
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WANT TO RECEIVE
THIS DOCUMENT
FASTER VIA EMAIL?
FRANKLIN
STRATEGIC MORTGAGE PORTFOLIO Eligible shareholders can
sign up for eDelivery at
franklintempleton.com.
See inside for details.
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[LOGO](R)
FRANKLIN(R) TEMPLETON(R)
INVESTMENTS

FRANKLIN o Templeton o Mutual Series

FRANKLIN TEMPLETON INVESTMENTS

GAIN FROM OUR PERSPECTIVE

Franklin Templeton's distinct multi-manager
structure combines the specialized expertise of
three world-class investment management
groups--Franklin, Templeton and Mutual Series.

SPECIALIZED EXPERTISE Each of our portfolio management groups
operates autonomously, relying on its own
research and staying true to the unique
investment disciplines that underlie its
success.

FRANKLIN. Founded in 1947, Franklin is a
recognized leader in fixed income investing and
also brings expertise in growth- and
value-style U.S. equity investing.

TEMPLETON. Founded in 1940, Templeton pioneered
international investing and, in 1954, launched
what has become the industry's oldest global
fund. Today, with research offices in over 25
countries, they offer investors the broadest
global reach in the industry.

MUTUAL SERIES. Founded in 1949, Mutual Series
is dedicated to a unique style of value
investing, searching aggressively for
opportunity among undervalued stocks, arbitrage
situations and distressed companies.

TRUE DIVERSIFICATION Because our management groups work
independently and adhere to distinctly
different investment approaches, Franklin,
Templeton and Mutual Series funds typically
have a low overlap of securities. That's why
our funds can be used to build truly
diversified portfolios covering every major
asset class.

RELIABILITY YOU CAN TRUST At Franklin Templeton Investments, we seek to
consistently provide investors with exceptional
risk-adjusted returns over the long term, as
well as the reliable account services that have
helped us become one of the most trusted names
in financial services.

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MUTUAL FUNDS | RETIREMENT PLANS | 529 COLLEGE SAVINGS PLANS | SEPARATE ACCOUNTS
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[GRAPHIC OMITTED]

Not part of the annual report

CONTENTS

SHAREHOLDER LETTER ........................................................ 1

ANNUAL REPORT

Franklin Strategic Mortgage Portfolio ..................................... 3

Performance Summary ....................................................... 8

Your Fund's Expenses ...................................................... 10

Financial Highlights and
Statement of Investments .................................................. 12

Financial Statements ...................................................... 19

Notes to Financial Statements ............................................. 22

Report of Independent Registered Public
Accounting Firm ........................................................... 30

Board Members and Officers ................................................ 31

Shareholder Information ................................................... 36

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ANNUAL REPORT

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

YOUR FUND'S GOAL AND MAIN INVESTMENTS: Franklin Strategic Mortgage Portfolio
seeks a high level of total return (a combination of high current income and
capital appreciation) relative to the performance of the general mortgage
securities market by investing at least 80% of its net assets in a portfolio of
mortgage securities. The Fund normally focuses its investments in mortgage
pass-through securities, which are securities representing interests in "pools"
of mortgage loans issued or guaranteed by the U.S. government, its agencies or
instrumentalities. Some of the Fund's investments may include securities issued
by government-sponsored entities, such as Fannie Mae and Freddie Mac.(1)

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PERFORMANCE DATA QUOTED REPRESENT PAST PERFORMANCE, WHICH DOES NOT GUARANTEE
FUTURE RESULTS. INVESTMENT RETURN AND PRINCIPAL VALUE WILL FLUCTUATE, AND YOU
MAY HAVE A GAIN OR LOSS WHEN YOU SELL YOUR SHARES. CURRENT PERFORMANCE MAY
DIFFER FROM FIGURES SHOWN. PLEASE VISIT FRANKLINTEMPLETON.COM OR CALL
1-800/342-5236 FOR MOST RECENT MONTH-END PERFORMANCE.
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This annual report for Franklin Strategic Mortgage Portfolio covers the fiscal
year ended September 30, 2004.

PERFORMANCE OVERVIEW

Franklin Strategic Mortgage Portfolio - Class A posted a +4.41% cumulative total
return for the 12 months ended September 30, 2004. The Fund's performance was
comparable to the benchmark index, the Citigroup Mortgage Index, which returned
4.43% for the same period.(2) For comparison, the Lipper U.S. Mortgage Funds
Objective Average returned 3.35%, and the Lehman Brothers

(1) U.S. government securities owned by the Fund or held under repurchase
agreement, but not shares of the Fund, are guaranteed by the U.S.
government, its agencies or instrumentalities as to the timely payment of
principal and interest. Although U.S. government-sponsored entities may be
chartered or sponsored by acts of Congress, their securities are neither
insured nor guaranteed by the U.S. Treasury. Please refer to the Fund's
prospectus for a detailed discussion regarding various levels of credit
support. Yield and share price are not guaranteed and will fluctuate with
market conditions.

(2) Source: Standard & Poor's Micropal. The Citigroup Mortgage Index, a
component of the Citigroup U.S. Broad Investment-Grade Bond Index, is a
total return index that includes approximately 186 GNMA, FNMA and FHLMC
issues. The index is unmanaged and includes reinvested distributions. One
cannot invest directly in an index, nor is an index representative of the
Fund's portfolio.

THE DOLLAR VALUE, NUMBER OF SHARES OR PRINCIPAL AMOUNT, AND NAMES OF ALL
PORTFOLIO HOLDINGS ARE LISTED IN THE FUND'S STATEMENT OF INVESTMENTS (SOI). THE
SOI BEGINS ON PAGE 13.

Annual Report | 3

U.S. Treasury Index returned 0.04%.(3) You can find the Fund's long-term
performance data in the Performance Summary beginning on page 8.

ECONOMIC AND MARKET OVERVIEW

Over the past 12 months, the confusing employment picture was a dominant topic.
While the unemployment rate declined to 5.4% on September 30, 2004, and there
was some job growth, job creation according to the most recent nonfarm payroll
statistics disappointed many market participants.(4) However, other sources,
such as one from the National Federation of Independent Businesses (NFIB) showed
stronger gains. The NFIB survey was particularly interesting, because small
businesses historically have created about two-thirds of all new U.S. jobs.(5)
As a result, many market participants believed that job growth was not
accurately reflected in the nonfarm payroll numbers. During the year under
review, more jobs combined with reductions in income tax helped to increase
consumers' disposable income and allowed them to continue spending. That
spending kept the economy growing.

Increases in business spending also contributed to economic growth. After
declining in 2001 and 2002, business spending posted strong results during the
period. For example, nonresidential investment spending increased 12.5% and
11.7% in the second and third quarters of 2004.(6) Historically low interest
rates during the reporting period allowed many businesses the opportunity to
refinance their old debt at more attractive levels. This helped enhance business
operating performance, and corporate profits reflected this data. Many corporate
debt products also benefited from this improvement. Productivity continued to
grow, which helped businesses generate more goods and services without
substantially raising inflation.

(3) Sources: Lipper Inc.; Lehman Brothers Inc. The Lipper U.S. Mortgage Funds
Objective Average is calculated by averaging the total return for all
funds within the Lipper U.S. Mortgage Funds classification in the Lipper
Open-End underlying funds universe for the period indicated. Lipper U.S.
Mortgage Funds are defined as funds that invest primarily in
mortgages/securities issued or guaranteed as to principal and interest by
the U.S. government and certain federal agencies. For the 12-month period
ended 9/30/04, the Lipper U.S. Mortgage Funds Objective Average consisted
of 78 funds. Lipper calculations do not include sales charges. The Fund's
performance relative to the average may have differed if these or other
factors had been considered. The Lehman Brothers U.S. Treasury Index
includes public obligations of the U.S. Treasury with a remaining maturity
of one year or more. All issues must have at least one year to final
maturity regardless of call features, have at least $250 million par
amount outstanding and be rated investment grade (Baa3 or better). They
must also be dollar denominated, nonconvertible and publicly issued. The
index excludes Treasury bills (because of the maturity constraint), flower
bonds, targeted investor notes (TINs), and state and local government
series (SLGs) bonds, STRIPS and Treasury Inflation-Protection Securities
(TIPS). Treasuries, if held to maturity, offer a fixed rate of return and
fixed principal value; their interest payments and principal are
guaranteed. The Fund's investment return and share price fluctuate with
market conditions. The indexes are unmanaged and include reinvestment of
any income or distributions. One cannot invest directly in an index, nor
is an index representative of the Fund's portfolio.

(4) Source: Bureau of Labor Statistics.

(5) Source: Dennis, William J., Jr., NFIB Research Foundation, "The Public
Reviews Small Business," 8/04.

(6) Source: Bureau of Economic Analysis.

4 | Annual Report

PORTFOLIO BREAKDOWN
Based on Total Long-Term Investments*

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9/30/04** 9/30/03
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30-Year Mortgage Pass-Throughs 57.8% 61.9%
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15-Year Mortgage Pass-Throughs 15.1% 14.5%
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Home Equity Loans & Manufactured Housing ABS 12.8% 8.1%
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Adjustable Rate Mortgages 12.0% 15.5%
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20-Year Mortgage Pass-Throughs 2.3% 0.0%
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* Total long-term investments do not include short-term investments.

** Liability for Forward Settlements equals -14.3% of total net assets.

Although energy prices rose 6.7% for the year under review, the core Consumer
Price Index, a measure of inflation excluding food and energy costs, rose a more
subdued 2.0% for the 12 months ended September 30, 2004.(4) Expected inflation
is a key determinant of interest rates, and this environment contributed to the
continued low level of interest rates during the period. The 10-year U.S.
Treasury yield rose modestly from 3.96% at the beginning of the fiscal year to
4.14% on September 30, 2004.

The general interest rate decline over the past few years has helped to provide
a certain amount of stimulus to consumers and businesses. Even with recently
rising interest rates, other sources of economic stimulus remained during the
period, including positive employment data as well as business strength.

DIVIDEND DISTRIBUTIONS*
10/1/03-9/30/04

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MONTH DIVIDEND PER SHARE
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October 4.3981 cents
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November 4.2498 cents
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December 4.9358 cents
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January 4.4851 cents
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February 4.4568 cents
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March 4.8100 cents
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April 4.3745 cents
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May 4.0786 cents
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June 5.1231 cents
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July 4.3785 cents
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August 4.5130 cents
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September 4.2206 cents
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TOTAL 54.0239 CENTS
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* Assumes shares were purchased and held for the entire accrual period.
Since dividends accrue daily, your actual distributions will vary
depending on the date you purchased your shares and any account activity.
All Fund distributions will vary depending upon current market conditions,
and past distributions are not indicative of future trends.

Annual Report | 5

INVESTMENT STRATEGY

We invest at least 80% of total net assets in mortgage-backed securities and
mortgage-related securities. Normally we focus on mortgage pass-through
securities issued by the Government National Mortgage Association (Ginnie Mae),
Fannie Mae and Freddie Mac. At least 65% of total net assets are invested in
securities rated AAA by Standard & Poor's (S&P) or Aaa by Moody's Investors
Service (Moody's), independent credit rating agencies. The remaining 35% of the
portfolio securities will be rated at least BBB by S&P or Baa by Moody's or, if
unrated, securities will be deemed of comparable quality by the Fund's manager.
We analyze securities using research to help identify attractive investment
opportunities.

MANAGER'S DISCUSSION

We began the period with a relatively heavy weighting in lower coupon (5%),
mortgage-backed securities. Toward the end of the period, however, we began to
shift some assets out of these 5% coupon securities into other areas. Primarily,
we looked to higher coupon issues for value. Our higher coupon positions offered
less price risk as interest rates rose. For further diversification, we also
increased allocation to mortgage-related asset-backed securities.

6 | Annual Report

Thank you for your continued participation in Franklin Strategic Mortgage
Portfolio. We look forward to serving your future investment needs.

/s/ Roger A. Bayston
[PHOTO OMITTED]
Roger A. Bayston, CFA

/s/ Kent Burns
[PHOTO OMITTED]
Kent Burns, CFA

/s/ Doug Magowan
[PHOTO OMITTED]
Doug Magowan

/s/ Paul Varunok
[PHOTO OMITTED]
Paul Varunok

Portfolio Management Team
Franklin Strategic Mortgage Portfolio

THE FOREGOING INFORMATION REFLECTS OUR ANALYSIS, OPINIONS AND PORTFOLIO HOLDINGS
AS OF SEPTEMBER 30, 2004, THE END OF THE REPORTING PERIOD. THE WAY WE IMPLEMENT
OUR MAIN INVESTMENT STRATEGIES AND THE RESULTING PORTFOLIO HOLDINGS MAY CHANGE
DEPENDING ON FACTORS SUCH AS MARKET AND ECONOMIC CONDITIONS. THESE OPINIONS MAY
NOT BE RELIED UPON AS INVESTMENT ADVICE OR AN OFFER FOR A PARTICULAR SECURITY.
THE INFORMATION IS NOT A COMPLETE ANALYSIS OF EVERY ASPECT OF ANY MARKET,
COUNTRY, INDUSTRY, SECURITY OR THE FUND. STATEMENTS OF FACT ARE FROM SOURCES
CONSIDERED RELIABLE, BUT THE ADVISER MAKES NO REPRESENTATION OR WARRANTY AS TO
THEIR COMPLETENESS OR ACCURACY. ALTHOUGH HISTORICAL PERFORMANCE IS NO GUARANTEE
OF FUTURE RESULTS, THESE INSIGHTS MAY HELP YOU UNDERSTAND OUR INVESTMENT
MANAGEMENT PHILOSOPHY.

Annual Report | 7

PERFORMANCE SUMMARY AS OF 9/30/04

Your dividend income will vary depending on dividends or interest paid by
securities in the Fund's portfolio, adjusted for operating expenses. Capital
gain distributions are net profits realized from the sale of portfolio
securities. The performance table and graph do not reflect any taxes due on Fund
dividends, capital gain distributions, if any, or any realized gains on the sale
of Fund shares. Total return reflects the Fund's dividend income, capital gain
distributions, if any, and any unrealized gains or losses.

PRICE AND DISTRIBUTION INFORMATION

- -----------------------------------------------------------------------------------------------
CLASS A CHANGE 9/30/04 9/30/03
- -----------------------------------------------------------------------------------------------

Net Asset Value (NAV) -$0.10 $9.96 $10.06
- -----------------------------------------------------------------------------------------------
DISTRIBUTIONS (10/1/03-9/30/04)
- -----------------------------------------------------------------------------------------------
Dividend Income $0.540239
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PERFORMANCE(1)

CLASS A: 4.25% MAXIMUM INITIAL SALES CHARGE. CUMULATIVE TOTAL RETURN EXCLUDES
THE SALES CHARGE. AVERAGE ANNUAL TOTAL RETURN INCLUDES THE MAXIMUM SALES CHARGE.

- -----------------------------------------------------------------------------------------------
CLASS A 1-YEAR 5-YEAR 10-YEAR
- -----------------------------------------------------------------------------------------------

Cumulative Total Return(2) +4.41% +40.99% +106.18%
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Average Annual Total Return(3) -0.06% +6.19% +7.04%
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Distribution Rate(4) 4.94%
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30-Day Standardized Yield(5) 3.62%
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PERFORMANCE DATA QUOTED REPRESENT PAST PERFORMANCE, WHICH DOES NOT GUARANTEE
FUTURE RESULTS. INVESTMENT RETURN AND PRINCIPAL VALUE WILL FLUCTUATE, AND YOU
MAY HAVE A GAIN OR LOSS WHEN YOU SELL YOUR SHARES. CURRENT PERFORMANCE MAY
DIFFER FROM FIGURES SHOWN.

FOR MOST RECENT MONTH-END PERFORMANCE, SEE "FUNDS AND PERFORMANCE" AT
FRANKLINTEMPLETON.COM OR CALL 1-800/342-5236.

8 | Annual Report

PERFORMANCE SUMMARY (CONTINUED)

TOTAL RETURN INDEX COMPARISON FOR HYPOTHETICAL $10,000 INVESTMENT(1)

Total return represents the change in value of an investment over the periods
shown. It includes the current maximum sales charge, Fund expenses, account fees
and reinvested distributions. The unmanaged index includes reinvestment of any
income or distributions. It differs from the Fund in composition and does not
pay management fees or expenses. One cannot invest directly in an index.

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO - CLASS A
Total Return Index Comparison
$10,000 Investment (10/1/94 - 9/30/04)

[THE FOLLOWING TABLE WAS REPRESENTED AS LINE GRAPH IN THE PRINTED MATERIAL.]

FRANKLIN STRATEGIC CITIGROUP
MORTGAGE PORTFOLIO MORTGAGE INDEX(6)
---------------------------------------------------------
10/1/1994 $9,573 $10,000
10/31/1994 $9,550 $9,998
11/30/1994 $9,525 $9,962
12/31/1994 $9,612 $10,044
1/31/1995 $9,809 $10,270
2/28/1995 $10,060 $10,532
3/31/1995 $10,094 $10,575
4/30/1995 $10,227 $10,716
5/31/1995 $10,560 $11,063
6/30/1995 $10,624 $11,121
7/31/1995 $10,639 $11,143
8/31/1995 $10,747 $11,246
9/30/1995 $10,843 $11,347
10/31/1995 $10,955 $11,250
11/30/1995 $11,075 $11,586
12/31/1995 $11,204 $11,729
1/31/1996 $11,297 $11,819
2/29/1996 $11,207 $11,725
3/31/1996 $11,158 $11,686
4/30/1996 $11,129 $11,632
5/31/1996 $11,094 $11,616
6/30/1996 $11,224 $11,765
7/31/1996 $11,276 $11,811
8/31/1996 $11,273 $11,813
9/30/1996 $11,460 $12,012
10/31/1996 $11,683 $12,245
11/30/1996 $11,846 $12,414
12/31/1996 $11,800 $12,359
1/31/1997 $11,882 $12,464
2/28/1997 $11,904 $12,478
3/31/1997 $11,861 $12,374
4/30/1997 $12,030 $12,562
5/31/1997 $12,135 $12,680
6/30/1997 $12,258 $12,826
7/31/1997 $12,454 $13,063
8/31/1997 $12,446 $13,040
9/30/1997 $12,588 $13,195
10/31/1997 $12,710 $13,337
11/30/1997 $12,741 $13,382
12/31/1997 $12,860 $13,505
1/31/1998 $12,981 $13,630
2/28/1998 $13,011 $13,672
3/31/1998 $13,058 $13,725
4/30/1998 $13,124 $13,802
5/31/1998 $13,217 $13,899
6/30/1998 $13,293 $13,960
7/31/1998 $13,353 $14,029
8/31/1998 $13,492 $14,156
9/30/1998 $13,684 $14,326
10/31/1998 $13,686 $14,310
11/30/1998 $13,771 $14,376
12/31/1998 $13,832 $14,448
1/31/1999 $13,913 $14,548
2/28/1999 $13,844 $14,494
3/31/1999 $13,923 $14,594
4/30/1999 $13,983 $14,666
5/31/1999 $13,891 $14,567
6/30/1999 $13,854 $14,534
7/31/1999 $13,774 $14,434
8/31/1999 $13,764 $14,426
9/30/1999 $13,999 $14,672
10/31/1999 $14,060 $14,749
11/30/1999 $14,073 $14,761
12/31/1999 $14,037 $14,713
1/31/2000 $13,928 $14,600
2/29/2000 $14,084 $14,772
3/31/2000 $14,227 $14,931
4/30/2000 $14,247 $14,938
5/31/2000 $14,261 $14,950
6/30/2000 $14,557 $15,273
7/31/2000 $14,656 $15,370
8/31/2000 $14,883 $15,597
9/30/2000 $15,063 $15,764
10/31/2000 $15,176 $15,881
11/30/2000 $15,406 $16,116
12/31/2000 $15,712 $16,374
1/31/2001 $15,936 $16,628
2/28/2001 $16,029 $16,720
3/31/2001 $16,136 $16,829
4/30/2001 $16,153 $16,846
5/31/2001 $16,246 $16,951
6/30/2001 $16,314 $16,974
7/31/2001 $16,588 $17,290
8/31/2001 $16,730 $17,448
9/30/2001 $16,961 $17,705
10/31/2001 $17,180 $17,945
11/30/2001 $17,075 $17,781
12/31/2001 $17,027 $17,717
1/31/2002 $17,183 $17,891
2/28/2002 $17,353 $18,086
3/31/2002 $17,173 $17,903
4/30/2002 $17,510 $18,237
5/31/2002 $17,633 $18,371
6/30/2002 $17,787 $18,519
7/31/2002 $17,997 $18,728
8/31/2002 $18,130 $18,893
9/30/2002 $18,283 $19,030
10/31/2002 $18,344 $19,102
11/30/2002 $18,339 $19,084
12/31/2002 $18,533 $19,286
1/31/2003 $18,578 $19,340
2/28/2003 $18,691 $19,473
3/31/2003 $18,712 $19,466
4/30/2003 $18,790 $19,540
5/31/2003 $18,835 $19,550
6/30/2003 $18,850 $19,592
7/31/2003 $18,490 $19,238
8/31/2003 $18,609 $19,364
9/30/2003 $18,905 $19,695
10/31/2003 $18,818 $19,628
11/30/2003 $18,879 $19,685
12/31/2003 $19,068 $19,877
1/31/2004 $19,191 $20,004
2/29/2004 $19,372 $20,177
3/31/2004 $19,426 $20,266
4/30/2004 $19,144 $19,910
5/31/2004 $19,106 $19,846
6/30/2004 $19,245 $20,018
7/31/2004 $19,389 $20,206
8/31/2004 $19,714 $20,538
9/30/2004 $19,738 $20,567

ENDNOTES

THE FUND'S SHARE PRICE AND YIELD MAY BE AFFECTED BY INTEREST RATE MOVEMENTS AND
MORTGAGE PREPAYMENTS. BOND PRICES GENERALLY MOVE IN THE OPPOSITE DIRECTION FROM
INTEREST RATES. THUS, AS THE PRICES OF BONDS IN THE FUND ADJUST TO A RISE IN
INTEREST RATES, THE FUND'S SHARE PRICE MAY DECLINE. THE FUND'S PROSPECTUS ALSO
INCLUDES A DESCRIPTION OF THE MAIN INVESTMENT RISKS.

(1) Past expense reductions by the Fund's manager increased the Fund's total
returns. If the manager had not taken this action, the Fund's total
returns would have been lower.

(2) Cumulative total return represents the change in value of an investment
over the periods indicated and does not include the sales charge.

(3) Average annual total return represents the average annual change in value
of an investment over the periods indicated and includes the current
maximum sales charge.

(4) Distribution rate is based on an annualization of September's 4.2206 cent
per share dividend and the maximum offering price of $10.40 on 9/30/04.

(5) Yield, calculated as required by the SEC, is based on the earnings of the
Fund's portfolio for the 30 days ended 9/30/04.

(6) Source: Standard & Poor's Micropal. The Citigroup Mortgage Index, a
component of the Citigroup U.S. Broad Investment-Grade Bond Index, is a
total return index that includes 186 GNMA, FNMA and FHLMC issues.

Annual Report | 9

YOUR FUND'S EXPENSES

As a Fund shareholder, you can incur two types of costs:

o Transaction costs, including sales charges (loads) on Fund purchases and
redemption fees; and

o Ongoing Fund costs, including management fees, distribution and service
(12b-1) fees, and other Fund expenses. All mutual funds have ongoing
costs, sometimes referred to as operating expenses.

The following table shows ongoing costs of investing in the Fund and can help
you understand these costs and compare them with those of other mutual funds.
The table assumes a $1,000 investment held for the six months indicated.

ACTUAL FUND EXPENSES

The first line (Actual) for each share class listed in the table below provides
actual account values and expenses. The "Ending Account Value" is derived from
the Fund's actual return, which includes the effect of Fund expenses.

You can estimate the expenses you paid during the period, by following these
steps. OF COURSE, YOUR ACCOUNT VALUE AND EXPENSES WILL DIFFER FROM THOSE IN THIS
ILLUSTRATION:

1. Divide your account value by $1,000.

IF AN ACCOUNT HAD AN $8,600 VALUE, THEN $8,600 / $1,000 = 8.6.

2. Multiply the result by the number under the heading "Expenses Paid During
Period."

IF EXPENSES PAID DURING PERIOD WERE $7.50, THEN 8.6 X $7.50 = $64.50.

In this illustration, the estimated expenses paid this period are $64.50.

HYPOTHETICAL EXAMPLE FOR COMPARISON WITH OTHER FUNDS

Information in the second line (Hypothetical) for each class in the table can
help you compare ongoing costs of investing in the Fund with those of other
mutual funds. This information may not be used to estimate the actual ending
account balance or expenses you paid during the period. The hypothetical "Ending
Account Value" is based on the actual expense ratio for each class and an
assumed 5% annual rate of return before expenses, which does not represent the
Fund's actual return. The figure under the heading "Expenses Paid During Period"
shows the hypothetical expenses your account would have incurred under this
scenario. You can compare this figure with the 5% hypothetical examples that
appear in shareholder reports of other funds.

10 | Annual Report

YOUR FUND'S EXPENSES (CONTINUED)

PLEASE NOTE THAT EXPENSES SHOWN IN THE TABLE ARE MEANT TO HIGHLIGHT ONGOING
COSTS AND DO NOT REFLECT ANY TRANSACTION COSTS, SUCH AS SALES CHARGES OR
REDEMPTION FEES. Therefore, the second line for each class is useful in
comparing ongoing costs only, and will not help you compare total costs of
owning different funds. In addition, if transaction costs were included, your
total costs would have been higher. Please refer to the Fund prospectus for
additional information on operating expenses.

- ----------------------------------------------------------------------------------------------------------
BEGINNING ACCOUNT ENDING ACCOUNT EXPENSES PAID DURING
CLASS A VALUE 3/31/04 VALUE 9/30/04 PERIOD* 3/31/04-9/30/04
- ----------------------------------------------------------------------------------------------------------

Actual $1,000 $1,016.10 $2.72
- ----------------------------------------------------------------------------------------------------------
Hypothetical (5% return before expenses) $1,000 $1,022.30 $2.73
- ----------------------------------------------------------------------------------------------------------

* Expenses are equal to the annualized expense ratio of 0.54%, multiplied by
the average account value over the period, multiplied by 183/366 to
reflect the one-half year period.

Annual Report | 11

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

FINANCIAL HIGHLIGHTS

-----------------------------------------------------------------
YEAR ENDED SEPTEMBER 30,
2004 2003 2002 2001 2000
-----------------------------------------------------------------

PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)

Net asset value, beginning of year ............................. $ 10.06 $ 10.36 $ 10.27 $ 9.77 $ 9.74
-----------------------------------------------------------------
Income from investment operations:

Net investment income(a) ...................................... .328 .285 .488 .657 .663

Net realized and unrealized gains (losses) .................... .112 .048 .280 .539 .043
-----------------------------------------------------------------
Total from investment operations ............................... .440 .333 .768 1.196 .706
-----------------------------------------------------------------

Less distributions from:

Net investment income ......................................... (.540) (.542) (.596) (.693) (.676)

Realized capital gain ......................................... -- (.091) (.082) -- --
-----------------------------------------------------------------
Total distributions ............................................ (.540) (.633) (.678) (.693) (.676)
-----------------------------------------------------------------
Redemption fees ................................................ --(c) -- -- -- --
-----------------------------------------------------------------
Net asset value, end of year ................................... $ 9.96 $ 10.06 $ 10.36 $ 10.27 $ 9.77
=================================================================

Total return(b) ................................................ 4.41% 3.40% 7.79% 12.60% 7.60%

RATIOS/SUPPLEMENTAL DATA

Net assets, end of year (000's) ................................ $376,848 $421,827 $407,701 $188,330 $49,572

Ratios to average net assets:

Expenses ...................................................... .54% .52% .54% .64% .63%

Expenses net of waiver and payments by affiliate .............. .54% .52% .25% --% --%

Net investment income ......................................... 3.29% 2.79% 4.78% 5.98% 6.87%

Portfolio turnover rate ........................................ 245.18% 288.41% 219.99% 310.95% 226.43%

Portfolio turnover rate excluding mortgage dollar rolls(d) ..... 50.14% 125.17% 87.47% 87.91% 42.00%

(a) Based on average daily shares outstanding.

(b) Total return does not reflect sales commissions and is not annualized for
periods less than one year.

(d) See Note 1(d) regarding mortgage dollar rolls.

12 | See notes to financial statements. | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2004

- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL AMOUNT VALUE
- -----------------------------------------------------------------------------------------------------------------------------------

FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) 34.0%
FHLMC 30-Year, 5.50%, 10/01/33 .................................................... $ 13,100,000 $ 13,280,125
FHLMC 30-Year, 6.00%, 10/01/30 .................................................... 19,148,865 19,777,177
FHLMC 30-Year, 8.00%, 4/01/08 - 5/01/17 ........................................... 68,653 74,759
FHLMC 30-Year, 8.50%, 2/01/17 ..................................................... 17,995 19,919
FHLMC 30-Year, 9.00%, 7/01/08 - 6/01/16 ........................................... 10,168 11,091
FHLMC 30-Year, 9.125%, 9/01/17 .................................................... 4,922 5,483
FHLMC Gold 15-Year, 4.50%, 10/01/18 - 2/01/19 ..................................... 21,382,257 21,367,437
FHLMC Gold 15-Year, 5.00%, 10/01/17 - 6/01/19 ..................................... 10,746,450 10,941,344
FHLMC Gold 15-Year, 5.50%, 10/01/18 - 4/01/19 ..................................... 3,887,156 4,022,428
(a)FHLMC Gold 15-Year, 6.50%, 3/01/09 - 4/01/11 ...................................... 13,233 14,021
(a)FHLMC Gold 15-Year, 7.00%, 6/01/09 - 7/01/11 ...................................... 13,697 14,538
FHLMC Gold 15-Year, 7.50%, 4/01/10 ................................................ 4,638 4,934
FHLMC Gold 15-Year, 8.00%, 1/01/10 - 12/01/12 ..................................... 319,897 341,276
FHLMC Gold 20-Year, 6.50%, 2/01/19 ................................................ 1,649,454 1,740,019
FHLMC Gold 30-Year, 5.00%, 10/01/33 - 7/01/34 ..................................... 27,362,467 27,136,242
FHLMC Gold 30-Year, 5.50%, 9/01/33 - 10/01/33 ..................................... 3,157,184 3,208,312
FHLMC Gold 30-Year, 6.00%, 7/01/28 - 10/01/33 ..................................... 1,207,273 1,249,127
FHLMC Gold 30-Year, 6.50%, 11/01/27 - 7/01/32 ..................................... 3,177,038 3,342,604
FHLMC Gold 30-Year, 7.00%, 9/01/21 - 7/01/32 ...................................... 8,601,700 9,142,527
FHLMC Gold 30-Year, 7.50%, 7/01/24 - 8/01/32 ...................................... 2,785,140 2,987,783
FHLMC Gold 30-Year, 8.00%, 7/01/24 - 5/01/30 ...................................... 377,794 413,590
FHLMC Gold 30-Year, 8.50%, 10/01/17 - 9/01/30 ..................................... 1,221,258 1,341,014
FHLMC Gold 30-Year, 9.00%, 9/01/30 ................................................ 730,615 809,764
FHLMC Gold 30-Year, 9.25%, 12/01/08 - 8/01/14 ..................................... 167,045 176,362
FHLMC Gold 30-Year, 9.50%, 12/01/16 - 4/01/25 ..................................... 2,902,108 3,273,132
FHLMC Gold 30-Year, 10.00%, 1/01/19 ............................................... 594,621 672,488
FHLMC PC 15-Year, 9.50%, 8/01/19 .................................................. 279,547 310,416
FHLMC PC 30-Year, 8.50%, 5/01/17 .................................................. 2,187,130 2,418,671
------------
128,096,583
------------
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) - ADJUSTABLE RATE 5.1%
FHLMC, ARM, 3.00%, 4/01/17 ........................................................ 136,874 137,943
FHLMC, ARM, 3.333%, 5/01/20 ....................................................... 564,812 581,820
FHLMC, ARM, 3.429%, 5/01/22 ....................................................... 357,796 371,467
FHLMC, ARM, 3.434%, 11/01/16 ...................................................... 895,560 918,128
FHLMC, ARM, 3.483%, 3/01/19 ....................................................... 420,799 435,530
FHLMC, ARM, 3.50%, 4/01/18 ........................................................ 222,161 230,295
FHLMC, ARM, 3.507%, 11/01/25 ...................................................... 185,673 188,567
FHLMC, ARM, 3.528%, 7/01/22 ....................................................... 2,957,737 3,042,917
FHLMC, ARM, 3.743%, 11/01/25 ...................................................... 928,664 963,901
FHLMC, ARM, 3.826%, 7/01/24 ....................................................... 456,194 473,205
FHLMC, ARM, 3.84%, 12/01/30 ....................................................... 375,276 393,031
FHLMC, ARM, 3.841%, 9/01/27 ....................................................... 421,838 434,266
FHLMC, ARM, 4.445%, 5/01/30 ....................................................... 824,659 851,592
FHLMC, ARM, 5.004%, 4/01/24 ....................................................... 573,298 586,672
FHLMC, ARM, 5.225%, 1/01/32 ....................................................... 1,096,894 1,138,319
FHLMC, ARM, 5.232%, 10/01/18 ...................................................... 449,278 458,247

Annual Report | 13

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2004 (CONTINUED)

FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) - ADJUSTABLE RATE (CONT.)
FHLMC, ARM, 5.745%, 1/01/31 ....................................................... $ 912,053 $ 940,479
FHLMC, ARM, 5.976%, 1/01/28 ....................................................... 583,103 592,765
FHLMC, ARM, 6.072%, 7/01/30 ....................................................... 1,048,629 1,075,067
FHLMC, ARM, 6.156%, 8/01/31 ....................................................... 251,898 260,271
FHLMC, ARM, 6.358%, 4/01/30 ....................................................... 4,514,033 4,622,203
FHLMC, ARM, 6.669%, 4/01/31 ....................................................... 196,184 200,302
FHLMC, ARM, 6.873%, 11/01/19 ...................................................... 388,126 400,489
------------
19,297,476
------------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) 30.9%
FNMA 15-Year, 5.00%, 6/01/18 - 7/01/18 ............................................ 10,082,309 10,273,283
FNMA 15-Year, 5.50%, 5/01/14 - 2/01/18 ............................................ 7,929,737 8,217,683
FNMA 15-Year, 6.00%, 1/01/11 - 5/01/17 ............................................ 7,668,763 8,049,877
FNMA 15-Year, 6.50%, 9/01/08 - 10/01/16 ........................................... 924,009 979,189
FNMA 15-Year, 7.00%, 7/01/09 - 11/01/11 ........................................... 4,417 4,689
FNMA 15-Year, 7.50%, 7/01/09 - 7/01/12 ............................................ 64,035 68,196
FNMA 20-Year, 6.50%, 5/01/16 - 5/01/19 ............................................ 7,730,177 8,159,449
FNMA 30-Year, 5.00%, 4/01/34 ...................................................... 1,984,721 1,966,949
(a)FNMA 30-Year, 5.50%, 9/01/33 - 10/15/34 ........................................... 42,360,778 42,962,088
(a)FNMA 30-Year, 6.00%, 12/01/23 - 10/01/28 .......................................... 4,240,052 4,385,837
FNMA 30-Year, 6.50%, 12/01/27 - 8/01/32 ........................................... 16,226,700 17,044,195
FNMA 30-Year, 7.00%, 6/01/24 - 6/01/31 ............................................ 4,403,000 4,674,628
FNMA 30-Year, 7.50%, 8/01/25 - 5/01/32 ............................................ 1,005,729 1,078,094
FNMA 30-Year, 8.00%, 7/01/16 - 7/01/31 ............................................ 208,582 227,307
FNMA 30-Year, 8.50%, 7/01/24 - 11/01/28 ........................................... 3,618,476 3,989,279
FNMA 30-Year, 9.00%, 8/01/09 - 9/01/26 ............................................ 1,143,301 1,254,324
FNMA 30-Year, 9.25%, 10/01/09 ..................................................... 15,066 15,839
FNMA 30-Year, 9.50%, 11/01/15 - 4/01/30 ........................................... 1,249,290 1,398,941
FNMA 30-Year, 10.00%, 7/01/16 - 4/01/21 ........................................... 1,060,796 1,190,583
FNMA 30-Year, 10.50%, 1/01/16 - 5/01/30 ........................................... 141,537 158,873
FNMA 30-Year, 11.00%, 10/01/15 - 6/01/30 .......................................... 226,775 258,418
FNMA 30-Year, 12.00%, 4/01/15 - 5/01/16 ........................................... 7,460 8,503
FNMA 30-Year, 12.50%, 9/01/13 - 12/01/13 .......................................... 2,260 2,600
FNMA PL, 30-Year, 10.00%, 9/01/20 ................................................. 26,309 29,583
------------
116,398,407
------------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) - ADJUSTABLE RATE 8.4%
FNMA, ARM, 2.713%, 7/01/17 ........................................................ 329,879 333,857
FNMA, ARM, 3.008%, 1/01/18 ........................................................ 3,732,607 3,802,729
FNMA, ARM, 3.281%, 7/01/27 ........................................................ 357,649 367,160
FNMA, ARM, 3.33%, 7/01/14 ......................................................... 831,628 851,035
FNMA, ARM, 3.343%, 6/01/25 ........................................................ 291,211 301,819
FNMA, ARM, 3.375%, 9/01/18 ........................................................ 63,715 65,250
FNMA, ARM, 3.386%, 4/01/18 ........................................................ 94,466 96,989
FNMA, ARM, 3.426%, 4/01/27 ........................................................ 490,306 504,342
FNMA, ARM, 3.45%, 8/01/27 ......................................................... 179,838 185,256
FNMA, ARM, 3.48%, 1/01/17 ......................................................... 983,810 1,008,421
FNMA, ARM, 3.548%, 5/01/27 ........................................................ 687,184 714,211

14 | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2004 (CONTINUED)

FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) - ADJUSTABLE RATE (CONT.)
FNMA, ARM, 3.55%, 7/01/25 ......................................................... $ 242,084 $ 248,785
FNMA, ARM, 3.55%, 7/01/19 ......................................................... 3,360,095 3,465,458
FNMA, ARM, 3.617%, 12/01/22 ....................................................... 443,196 455,698
FNMA, ARM, 3.642%, 11/01/31 ....................................................... 2,207,172 2,278,155
FNMA, ARM, 3.744%, 8/01/29 ........................................................ 367,011 380,307
FNMA, ARM, 3.786%, 4/01/21 ........................................................ 163,533 167,151
FNMA, ARM, 3.878%, 10/01/29 ....................................................... 224,986 233,058
FNMA, ARM, 3.903%, 5/01/27 ........................................................ 1,540,990 1,582,878
FNMA, ARM, 3.953%, 10/01/24 ....................................................... 1,114,958 1,151,910
FNMA, ARM, 3.97%, 5/01/25 ......................................................... 59,015 60,547
FNMA, ARM, 3.987%, 7/01/26 ........................................................ 104,243 106,556
FNMA, ARM, 4.006%, 10/01/29 ....................................................... 633,156 654,933
FNMA, ARM, 4.258%, 8/01/26 ........................................................ 475,563 493,734
FNMA, ARM, 4.264%, 8/01/30 ........................................................ 669,621 695,850
FNMA, ARM, 4.49%, 2/01/32 ......................................................... 511,366 524,197
FNMA, ARM, 4.505%, 10/01/19 ....................................................... 756,747 761,108
FNMA, ARM, 5.11%, 6/01/17 ......................................................... 228,344 235,144
FNMA, ARM, 5.16%, 12/01/31 ........................................................ 624,749 639,673
FNMA, ARM, 5.176%, 8/01/32 ........................................................ 272,085 277,604
FNMA, ARM, 5.393%, 5/01/28 ........................................................ 1,198,466 1,244,835
FNMA, ARM, 5.48%, 5/01/21 ......................................................... 682,554 706,722
FNMA, ARM, 5.523%, 1/01/32 ........................................................ 436,271 443,154
FNMA, ARM, 5.765%, 5/01/30 ........................................................ 207,225 213,969
FNMA, ARM, 5.908%, 8/01/29 ........................................................ 119,338 122,486
FNMA, ARM, 5.91%, 10/01/32 ........................................................ 488,255 501,694
FNMA, ARM, 5.95%, 4/01/18 ......................................................... 239,998 248,722
FNMA, ARM, 5.964%, 7/01/31 ........................................................ 305,297 312,355
FNMA, ARM, 5.994%, 7/01/31 ........................................................ 2,355,375 2,436,053
FNMA, ARM, 6.009%, 6/01/31 ........................................................ 1,174,651 1,199,877
FNMA, ARM, 6.043%, 5/01/31 ........................................................ 108,972 112,016
FNMA, ARM, 6.125%, 11/01/28 ....................................................... 201,809 204,675
FNMA, ARM, 6.144%, 12/01/24 ....................................................... 228,718 238,558
FNMA, ARM, 6.48%, 4/01/31 ......................................................... 327,444 335,963
FNMA, ARM, 7.279%, 9/01/32 ........................................................ 468,829 487,495
FNMA, ARM, 8.295%, 6/01/30 ........................................................ 83,784 85,524
------------
31,537,913
------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) 20.7%
GNMA I 15-Year, SF, 7.00%, 4/15/14 ................................................ 149,599 159,667
GNMA I 15-Year, SF, 8.00%, 9/15/15 ................................................ 178,425 191,726
GNMA I 30-Year, SF, 10.00%, 10/15/18 - 2/15/19 .................................... 36,162 40,825
GNMA I 30-Year, SF, 10.50%, 1/15/16 ............................................... 1,379 1,460
GNMA I 30-Year, SF, 5.00%, 5/15/34 ................................................ 9,745,994 9,714,067
GNMA I 30-Year, SF, 5.50%, 9/15/33 - 6/15/34 ...................................... 3,394,539 3,460,839
GNMA I 30-Year, SF, 6.00%, 2/15/29 - 12/15/33 ..................................... 3,284,683 3,411,731
GNMA I 30-Year, SF, 6.50%, 1/15/24 - 9/15/32 ...................................... 1,638,201 1,731,782
GNMA I 30-Year, SF, 7.00%, 10/15/09 - 11/15/29 .................................... 3,084,606 3,278,179
GNMA I 30-Year, SF, 7.50%, 10/15/23 - 10/15/29 .................................... 338,675 365,628

Annual Report | 15

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2004 (CONTINUED)

GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) (CONT.)
GNMA I 30-Year, SF, 8.00%, 1/15/17 - 1/15/28 ............................................... $ 961,417 $ 1,054,595
GNMA I 30-Year, SF, 8.25%, 4/15/06 - 10/15/21 .............................................. 584,231 635,777
GNMA I 30-Year, SF, 8.50%, 6/15/16 - 8/15/26 ............................................... 900,546 998,118
GNMA I 30-Year, SF, 9.00%, 1/15/05 - 8/15/28 ............................................... 309,733 339,617
GNMA I 30-Year, SF, 9.50%, 10/15/09 - 10/15/20 ............................................. 233,943 257,893
GNMA II 15-Year, SF, 9.00%, 8/20/06 - 12/20/06 ............................................. 2,900 3,014
GNMA II 30-Year, SF, 5.00%, 9/20/33 - 1/20/34 .............................................. 22,793,690 22,689,526
GNMA II 30-Year, SF, 6.00%, 3/20/34 - 6/20/34 .............................................. 13,989,860 14,518,663
GNMA II 30-Year, SF, 6.50%, 1/20/26 - 2/20/34 .............................................. 3,624,836 3,825,851
GNMA II 30-Year, SF, 7.00%, 3/20/27 - 11/20/32 ............................................. 6,130,641 6,527,167
GNMA II 30-Year, SF, 7.50%, 11/20/22 - 7/20/32 ............................................. 3,812,187 4,093,925
GNMA II 30-Year, SF, 8.00%, 8/20/26 ........................................................ 1,228 1,341
GNMA II 30-Year, SF, 9.00%, 11/20/19 - 3/20/25 ............................................. 23,778 26,751
GNMA II 30-Year, SF, 10.50%, 6/20/20 ....................................................... 96 104
GNMA II 30-Year, SF, 7.50%, 6/20/17 ........................................................ 57,130 61,566
GNMA II 30-Year, SF, 8.00%, 1/20/17 - 7/20/17 .............................................. 396,252 431,887
GNMA II 30-Year, SF, 8.50%, 7/20/16 - 8/20/16 .............................................. 97,115 107,113
-----------
77,928,812
-----------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), ADJUSTABLE RATE .2%
GNMA, SF, ARM, 4.625%, 11/20/25 ............................................................ 210,252 214,291
GNMA, SF, ARM, 4.75%, 7/20/27 .............................................................. 687,020 696,673
-----------
910,964
-----------
HOME EQUITY ASSET-BACKED SECURITIES 12.6%
AFC Home Equity Loan Trust, 1997-4, 2A2, Margin .24% + 1 Month LIBOR, Resets Monthly
1.33%, 12/22/27 .......................................................................... 1,762,292 1,764,782
Ameriquest Mortgage Securities Inc., 2002-3, AF5, 5.47%, 8/25/32 ........................... 793,482 793,875
Asset Backed Funding Certificates, 2001-AQ1, M1, 6.863%, 5/20/32 ........................... 6,000,000 6,136,851
Chase Funding Mortgage Loan Asset Backed Certificates, 1993-3, IIA1, 5.7125%, 9/25/29 ...... 333,796 334,125
Chase Funding Mortgage Loan Asset-Backed Certificates, 2003-6, 1A4, 4.499%, 8/25/30 ........ 10,000,000 10,038,529
Citifinancial Mortgage Securities Inc., 2003-1, AF3, 4.001%, 1/25/33 ....................... 4,000,000 4,024,354
Contimortgage Home Equity Loan Trust, 99-3, A6, 7.68%, 12/25/29 ............................ 552,534 569,048
Countrywide Asset-Backed Certificates, 2004-7, AF4, 4.774%, 8/25/32 ........................ 2,862,000 2,861,960
FNMA Grantor Trust, 2003-T4, 2A3, 2.859%, 12/26/29 ......................................... 496,262 497,887
Morgan Stanley Capital I, 2002-NC4, A2, Margin .40% + 1 Month LIBOR, Resets Monthly
2.23%, 9/25/32 ........................................................................... 1,064,992 1,067,432
Residential Asset Mortgage Products Inc., 2004-RS3, AI3, 4.237%, 6/25/31 ................... 3,700,000 3,628,194
Residential Asset Securities Corp., 2000-KS2, AII, Margin .25% + 1 Month LIBOR, Resets
Monthly 1.34%, 3/25/30 ................................................................... 2,772,506 2,776,447
Residential Asset Securities Corp., 2004-KS1, AI4, 4.213%, 4/25/32 ......................... 2,500,000 2,477,948
Residential Funding Mortgage Securities II, 2004-HI2, A4, 5.24%, 9/25/18 ................... 5,000,000 5,125,869
Residential Funding Mortgage Securities II, 2002-HI5, A4, 4.04%, 7/25/15 ................... 2,500,000 2,515,786
Residential Funding Mortgage Securities II, 2004-HS1, AI4, 3.77%, 1/25/22 .................. 3,000,000 2,903,906
-----------
47,516,993
-----------

16 | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2004 (CONTINUED)

MISCELLANEOUS MORTGAGE-BACKED SECURITIES 1.9%
Travelers Mortgage Services Inc., 4.119%, 12/25/18 ......................... $ 250,696 $ 256,235
Vanderbilt Mortgage Finance, 6.75%, 10/07/28 ............................... 100,000 105,556
Wells Fargo Home Equity Trust, 2004-2, A15, 4.87%, 11/25/28 ................ 6,868,000 6,902,347
-------------
7,264,138
-------------
TOTAL LONG TERM INVESTMENTS (COST $425,720,195) ............................ 428,951,286
-------------

----------------
SHARES
----------------

SHORT TERM INVESTMENT (COST $12,361,831) 3.3%
MONEY FUND
(b)Franklin Institutional Fiduciary Trust Money Market Portfolio .............. 12,361,831 12,361,831
-------------

----------------
PRINCIPAL AMOUNT
----------------

U.S. GOVERNMENT AND AGENCY SECURITIES (COST $199,569) .1%
(c),(d)U.S. Treasury Bill, 11/18/04 ............................................... $ 200,000 199,569
-------------
TOTAL INVESTMENTS (COST $438,281,596) 117.2% ............................... 441,512,686
OTHER ASSETS, LESS LIABILITIES (17.2)% ..................................... (64,664,618)
-------------
NET ASSETS 100.0% .......................................................... $ 376,848,068
=============

(a) See Note 1(b) regarding securities purchased on a to-be-announced basis.

(b) See Note 7 regarding investments in Franklin Institutional Fiduciary Trust
Money Market Portfolio.

(d) Security is traded on a discount basis with a zero coupon.

Annual Report | See notes to financial statements. | 17

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2004 (CONTINUED)

GLOSSARY OF TERMS

ARM - Adjustable Rate Mortgage
LIBOR - London InterBank Offering Rate
PC - Participation Certificate
PL - Project Loan
SF - Single Family

18 | See notes to financial statements. | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

FINANCIAL STATEMENTS

STATEMENT OF ASSETS AND LIABILITIES
September 30, 2004

Assets:
Investments in securities:
Cost - Unaffiliated issuers ........................................................... $ 425,919,765
Cost - Sweep Money Fund (Note 7) ...................................................... 12,361,831
-------------
Value - Unaffiliated issuers .......................................................... 429,150,855
Value - Sweep Money Fund (Note 7) ..................................................... 12,361,831
Receivables:
Investment securities sold ............................................................ 414,958
Capital shares sold ................................................................... 867,496
Interest .............................................................................. 1,653,916
-------------
Total assets ...................................................................... 444,449,056
-------------
Liabilities:
Payables:
Investment securities purchased ....................................................... 66,274,026
Capital shares redeemed ............................................................... 845,921
Affiliates ............................................................................ 138,989
Distributions to shareholders .......................................................... 262,884
Other liabilities ...................................................................... 79,168
-------------
Total liabilities ................................................................. 67,600,988
-------------
Net assets, at value ............................................................. $ 376,848,068
=============
Net assets consist of:
Distributions in excess of net investment income ....................................... $ (367,933)
Net unrealized appreciation (depreciation) ............................................. 3,225,981
Accumulated net realized gain (loss) ................................................... (10,470,679)
Capital shares ......................................................................... 384,460,699
-------------
Net assets, at value ............................................................. $ 376,848,068
=============
Net assets, at value ................................................................... $ 376,848,068
=============
Shares outstanding ..................................................................... 37,824,040
=============
Net asset value per share(a) ........................................................... $ 9.96
=============
Maximum offering price per share (net asset value per share / 95.75%) .................. $ 10.40
=============

(a) Redemption price is equal to net asset value less any applicable
contingent deferred sales charge and redemption fees retained by the Fund.

Annual Report | See notes to financial statements. | 19

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

FINANCIAL STATEMENTS (CONTINUED)

STATEMENT OF OPERATIONS
for the year ended September 30, 2004

Investment income:
Dividends from Sweep Money Fund ......................................................... $ 101,641
Interest ................................................................................ 15,008,396
------------
Total investment income ............................................................ 15,110,037
------------
Expenses:
Management fees (Note 3) ................................................................ 1,506,812
Transfer agent fees (Note 3) ............................................................ 455,983
Custodian fees (Note 4) ................................................................. 9,758
Reports to shareholders ................................................................. 30,132
Registration and filing fees ............................................................ 41,308
Professional fees ....................................................................... 37,040
Trustees' fees and expenses ............................................................. 24,272
Other ................................................................................... 33,438
------------
Total expenses ..................................................................... 2,138,743
Expense reductions (Note 4) ........................................................ (338)
------------
Net expenses ...................................................................... 2,138,405
------------
Net investment income ............................................................ 12,971,632
------------
Realized and unrealized gains (losses):
Net realized gain (loss) from:
Investments ............................................................................ 3,963,872
Financial futures contracts ............................................................ (11,194)
------------
Total net gain (loss) from investments .............................................. 3,952,678
Net change in unrealized appreciation (depreciation) on investments ..................... (66,011)
------------
Net realized and unrealized gain (loss) .................................................. 3,886,667
------------
Net increase (decrease) in net assets resulting from operations .......................... $ 16,858,299
============

20 | See notes to financial statements. | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

FINANCIAL STATEMENTS (CONTINUED)

STATEMENTS OF CHANGES IN NET ASSETS
for the years ended September 30, 2004 and 2003

--------------------------------
2004 2003
--------------------------------

Increase (decrease) in net assets:
Operations:
Net investment income ............................................................. $ 12,971,632 $ 12,130,000
Net realized gain (loss) from investments and financial futures ................... 3,952,678 6,009,287
Net unrealized appreciation (depreciation) on investments ......................... (66,011) (3,978,112)
--------------------------------
Net increase (decrease) in net assets resulting from operations ............... 16,858,299 14,161,175
Distributions to shareholders from:
Net investment income ............................................................. (21,406,995) (23,092,475)
Net realized gains ................................................................ -- (3,766,405)
--------------------------------
Total distributions to shareholders ................................................. (21,406,995) (26,858,880)
Capital share transactions (Note 2) ................................................. (40,430,232) 26,823,466
--------------------------------
Redemption fees ..................................................................... 52 --
--------------------------------
Net increase (decrease) in net assets ......................................... (44,978,876) 14,125,761
Net assets:
Beginning of year ................................................................... 421,826,944 407,701,183
--------------------------------
End of year ......................................................................... $ 376,848,068 $ 421,826,944
================================
Distributions in excess of net investment income included in net assets:
End of year ......................................................................... $ (367,933) $ (472,622)
================================

Annual Report | See notes to financial statements. | 21

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS

1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Franklin Strategic Mortgage Portfolio (the Trust) is registered under the
Investment Company Act of 1940 as a diversified, open-end investment company,
consisting of one Fund, the Franklin Strategic Mortgage Portfolio (the Fund).
The Fund seeks total return. The following summarizes the Fund's significant
accounting policies.

A. SECURITY VALUATION

Securities listed or traded on a recognized national exchange are valued at the
last reported sales price. Securities listed or traded on NASDAQ are valued at
their official closing price. Debt securities, other over-the-counter securities
and listed securities for which no sale is reported are valued within the range
of the latest quoted bid and asked prices by independent pricing services or
recognized dealers in such securities. Mortgage-backed and asset-backed
securities may be valued by the pricing services using matrix pricing which
considers such factors as prices of comparable quality issues, prepayment
speeds, yield, maturity, coupon, and credit ratings. If events occur that
materially affect the values of securities after the prices are determined, but
prior to 4:00 p.m. Eastern time or the close of trading on the NYSE, whichever
is earlier, or if market quotations are deemed not readily available or
reliable, the securities will be valued at fair value. Investments in open-end
mutual funds are valued at the closing net asset value. All security valuation
procedures are approved by the Board of Trustees.

B. SECURITIES PURCHASED ON A TBA BASIS

The Fund may purchase securities on a to-be-announced (TBA) basis, with payment
and delivery scheduled for a future date. These transactions are subject to
market fluctuations and are subject to the risk that the value at delivery may
be more or less than the trade date purchase price. Although the Fund will
generally purchase these securities with the intention of holding the
securities, it may sell the securities before the settlement date. Sufficient
assets have been segregated for these securities.

C. FUTURES CONTRACTS

The Fund may purchase financial futures contracts to gain exposure to market
changes. A financial futures contract is an agreement between two parties to buy
or sell a security for a set price on a future date. Required initial margin
deposits of cash or securities are maintained by the Fund's custodian in
segregated accounts as disclosed in the Statement of Investments. Subsequent
payments, known as variation margin, are made or received by the Fund depending
on the fluctuations in the value of the underlying securities. Such variation
margin is accounted for as unrealized gains or losses until the contract is
closed, at which time the gains or losses are reclassified to realized. Realized
and unrealized gains and losses on these contracts are included in the Statement
of Operations.

The risks of these contracts include the possibility there may be an illiquid
secondary market and/or a change in the value of the contract may not correlate
with the changes in the value of the underlying securities.

22 | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

D. MORTGAGE DOLLAR ROLLS

The Fund enters into mortgage dollar rolls, typically on a TBA basis. Dollar
rolls are agreements between the Fund and a financial institution to
simultaneously sell and repurchase a mortgage-backed security at a future date.
Gains or losses are realized at the time of the sale and the difference between
the repurchase price and sale price is recorded as an unrealized gain to the
Fund. The risks of mortgage dollar roll transactions include the potential
inability of the counterparty to fulfill their obligations.

E. INCOME TAXES

No provision has been made for income taxes because the Fund's policy is to
qualify as a regulated investment company under Sub Chapter M of the Internal
Revenue Code and to distribute substantially all of its taxable income. Fund
distributions to shareholders are determined on an income tax basis and may
differ from net investment income and realized gains for financial reporting
purposes.

F. SECURITY TRANSACTIONS, INVESTMENT INCOME, EXPENSES AND DISTRIBUTIONS

Security transactions are accounted for on trade date. Realized gains and losses
on security transactions are determined on a specific identification basis.
Interest income and estimated expenses are accrued daily. Discounts on
securities purchased are amortized over the lives of the respective securities.
Dividends from net investment income are normally declared daily and distributed
monthly to shareholders.

G. ACCOUNTING ESTIMATES

The preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the amounts of income
and expense during the reporting period. Actual results could differ from those
estimates.

H. REDEMPTION FEES

Effective June 1, 2004, redemptions and exchanges of the Fund's shares held five
trading days or less may be subject to the Fund's redemption fee, which is 2% of
the amount redeemed. Such fees are retained by the Fund and accounted for as
additional paid-in capital as noted in the Statement of Changes.

Annual Report | 23

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

I. GUARANTEES AND INDEMNIFICATIONS

Under the Trust's organizational documents, its officers and trustees are
indemnified against certain liability arising out of the performance of their
duties to the Trust. Additionally, in the normal course of business, the Trust
enters into contracts with service providers that contain general
indemnification clauses. The Trust's maximum exposure under these arrangements
is unknown as this would involve future claims that may be made against the
Trust that have not yet occurred. However, based on experience, the Trust
expects the risk of loss to be remote.

2. SHARES OF BENEFICIAL INTEREST

At September 30, 2004, there were an unlimited number of shares authorized
($0.01 par value). Transactions in the Fund's shares were as follows:

-------------------------------------------------------------
YEAR ENDED SEPTEMBER 30,
2004 2003
-------------------------------------------------------------
SHARES AMOUNT SHARES AMOUNT
-------------------------------------------------------------

Shares sold ................................ 9,677,050 $ 96,610,106 16,477,900 $ 168,508,139
Shares issued in reinvestment
of distributions .......................... 1,741,712 17,351,096 2,108,653 21,507,173
Shares redeemed ............................ (15,506,489) (154,391,434) (16,044,902) (163,191,846)
-------------------------------------------------------------
Net increase (decrease) .................... (4,087,727) $ (40,430,232) 2,541,651 $ 26,823,466
=============================================================

3. TRANSACTION WITH AFFILIATES

Certain officers and trustees of the Fund are also officers and/or directors of
the following entities.

- -----------------------------------------------------------------------------------------
ENTITY AFFILIATION
- -----------------------------------------------------------------------------------------

Franklin Advisers, Inc. (Advisers) Investment manager
Franklin/Templeton Services, LLC (FT Services) Administrative manager
Franklin/Templeton Distributors, Inc. (Distributors) Principal underwriter
Franklin/Templeton Investor Services, LLC (Investor Services) Transfer agent

A. MANAGEMENT FEES

The Fund pays an investment management fee to Advisers based on the average
daily net assets of the Fund as follows:

- -----------------------------------------------------------------------------------------
ANNUALIZED FEE RATE AVERAGE DAILY NET ASSETS
- -----------------------------------------------------------------------------------------

.40% First $250 million
.38% Over $250 million, up to and including $500 million
.36% In excess of $500 million

24 | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

3. TRANSACTION WITH AFFILIATES (CONTINUED)

B. ADMINISTRATIVE FEES

Under an agreement with Advisers, FT Services provides administrative services
to the Fund. The fee is paid by Advisers based on average daily net assets, and
is not an additional expense of the Fund.

C. SALES CHARGES/UNDERWRITING AGREEMENTS

Distributors has advised the Fund of the following commission transactions
related to the sale of the Fund's shares for the year:

Sales charges received .............................................. $ 89,312
Contingent deferred sales charges retained .......................... $ 4,897

D. TRANSFER AGENT FEES

The Fund paid transfer agent fees of $455,983, of which $268,940 was paid to
Investor Services.

E. OTHER AFFILIATED TRANSACTIONS

At September 30, 2004, Advisers owned 17.88% of the Fund.

4. EXPENSE OFFSET ARRANGEMENT

The Fund has entered into an arrangement with its custodian whereby credits
realized as a result of uninvested cash balances are used to reduce a portion of
the Fund's custodian expenses. During the year ended September 30, 2004, the
custodian fees were reduced as noted in the Statement of Operations.

5. INCOME TAXES

At September 30, 2004, the Fund had tax basis capital losses of $6,223,578 which
may be carried over to offset future capital gains. Such losses expire in 2012.

Net investment income (loss) differs for financial statement and tax purposes
primarily due to differing treatments of mortgage dollar roll transactions and
paydown losses.

Net realized gains (losses) differ for financial statement and tax purposes
primarily due to differing treatment of wash sales, financial futures
transactions, mortgage dollar roll, and paydown losses.

At September 30, 2004, the Fund had deferred capital losses occurring subsequent
to October 31, 2003 of $4,236,379. For tax purposes, such losses will be
reflected in the year ending September 30, 2005.

Annual Report | 25

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

5. INCOME TAXES (CONTINUED)

At September 30, 2004, the cost of investments, net unrealized appreciation
(depreciation), undistributed ordinary income and undistributed long term
capital gains for income tax purposes were as follows:

Cost of investments .................................... $ 438,805,413
=============
Unrealized appreciation ................................ $ 3,838,425
Unrealized depreciation ................................ (1,131,152)
-------------
Net unrealized appreciation ............................ $ 2,707,273
=============
Undistributed ordinary income .......................... $ 402,948
Undistributed long term capital gains .................. --
-------------
Distributable earnings ................................. $ 402,948
=============

The tax character of distributions paid during the years ended September 30,
2004 and 2003, were as follows:

-------------------------------
2004 2003
-------------------------------
Distributions paid from:
Ordinary income ....................... $21,406,995 $26,597,758
Long-term capital gain ................ -- 261,122
-------------------------------
$21,406,995 $26,858,880
===============================

6. INVESTMENT TRANSACTIONS

Purchases and sales of investments (excluding short-term securities) for the
year ended September 30, 2004 aggregated $1,079,874,241 and $1,133,389,133,
respectively.

7. INVESTMENTS IN FRANKLIN INSTITUTIONAL FIDUCIARY TRUST MONEY MARKET PORTFOLIO

The Fund may invest in the Franklin Institutional Fiduciary Trust Money Market
Portfolio (the Sweep Money Fund), an open-end investment company managed by
Advisers. Management fees paid by the Fund are reduced on assets invested in the
Sweep Money Fund, in an amount not to exceed the management fees paid by the
Sweep Money Fund.

8. FINANCIAL FUTURES CONTRACTS

As of September 30, 2004, the Fund had the following financial futures contracts
outstanding:

- --------------------------------------------------------------------------------------------------------
NUMBER OF CONTRACT UNREALIZED
CONTRACTS TO SELL CONTRACTS DELIVERY DATES FACE VALUE GAIN (LOSS)
- --------------------------------------------------------------------------------------------------------

U.S. Treasury 5 Year Note ................... 100 12/01/04 $10,000,000 $(5,109)

26 | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

9. REGULATORY MATTERS

MASSACHUSETTS ADMINISTRATIVE PROCEEDING

On September 20, 2004, Franklin Resources, Inc. (Franklin Resources, Inc. and
its subsidiaries are referred to collectively as the "Company") announced that
an agreement has been reached by two of its subsidiaries, Franklin Advisers,
Inc. ("Franklin Advisers") and Franklin Templeton Alternative Strategies, Inc.
("FTAS"), with the Securities Division of the Office of the Secretary of the
Commonwealth of Massachusetts (the "State of Massachusetts") related to an
administrative complaint filed on February 4, 2004. The administrative complaint
addressed one instance of market timing that was also a subject of the August 2,
2004 settlement that Franklin Advisers reached with the SEC, as described below.

Under the terms of the settlement consent order issued by the State of
Massachusetts, Franklin Advisers and FTAS have consented to the entry of a
cease-and-desist order and agreed to pay a $5 million administrative fine to the
State of Massachusetts. The consent order has multiple sections, including
"Statements of Fact" and "Violations of Massachusetts Securities Laws." The
Company admitted the "Statements of Fact." The Company did not admit or deny the
"Violations of the Massachusetts Securities Laws." While Franklin Advisers and
FTAS did not admit or deny engaging in any wrongdoing, the Company believes that
it is in its best interest and the interests of its funds' shareholders to
settle this issue now and move forward.

On October 25, 2004, the State of Massachusetts filed an administrative
complaint against Franklin Resources, Inc. ("FRI") alleging a violation of the
Massachusetts Uniform Securities law (the "Act") in connection with having filed
on September 20, 2004, an allegedly false and misleading report on Form 8-K with
the SEC. The Massachusetts administrative complaint seeks an order calling for
FRI to cease and desist from further violations of the Act and to pay an
administrative fine in an amount to be determined.

FRI's SEC filing of September 20, 2004 described the settlement consent order
with the State of Massachusetts and reported while "Franklin Advisers and FTAS
did not admit or deny engaging in any wrongdoing, the Company believes that it
is in the best interest of the Company and its funds' shareholders to settle
this issue now and move forward." The October 25, 2004 State of Massachusetts
administrative complaint alleges that this description of the settlement consent
order was materially false and misleading under Massachusetts law. FRI's
management disagrees with the allegation made in this administrative complaint
and continues to believe that the description of the terms of the settlement
consent order issued by the State of Massachusetts is neither false nor
misleading.

U.S. SECURITIES AND EXCHANGE COMMISSION (SEC) SETTLEMENT

On August 2, 2004, the Company announced that an agreement has been reached by
Franklin Advisers with the SEC that resolves the issues resulting from the SEC's
investigation of market timing activity and the SEC issued an "Order instituting
administrative and cease-and-desist proceedings pursuant to sections 203(e) and
203(k) of the Investment Advisers Act of 1940 and

Annual Report | 27

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

9. REGULATORY MATTERS (CONTINUED)

U.S. SECURITIES AND EXCHANGE COMMISSION (SEC) SETTLEMENT (CONTINUED)

sections 9(b) and 9(f) of the Investment Company Act of 1940, making findings
and imposing remedial sanctions and a cease-and-desist order" (the "Order"). The
SEC's Order concerns the activities of a limited number of third parties that
ended in 2000 and those that are the subject of the Massachusetts administrative
complaint described above.

Under the terms of the SEC's Order, pursuant to which Franklin Advisers neither
admits nor denies any wrongdoing, Franklin Advisers has agreed to pay $50
million, of which $20 million is a civil penalty, to be distributed to
shareholders of certain funds in accordance with a plan to be developed by an
Independent Distribution Consultant. At this time, it is unclear which funds
will receive distributions or which shareholders of any particular fund will
receive distributions. The SEC Order also requires Franklin Advisers to, among
other things, enhance and periodically review compliance policies and
procedures.

OTHER GOVERNMENTAL INVESTIGATIONS

As part of ongoing investigations by the SEC, the U.S. Attorney for the Northern
District of California, the New York Attorney General, the California Attorney
General, the U.S. Attorney for the District of Massachusetts, the Florida
Department of Financial Services and the Commissioner of Securities, the West
Virginia Attorney General, the Vermont Department of Banking, Insurance,
Securities, and Health Care Administration and the National Association of
Securities Dealers, relating to certain practices in the mutual fund industry,
including late trading, market timing and payments to securities dealers who
sell fund shares, the Company and its subsidiaries, as well as certain current
or former executives and employees of the Company, have received requests for
information and/or subpoenas to testify or produce documents. The Company and
its current employees have been providing documents and information in response
to these requests and subpoenas. In addition, the Company has responded to
requests for similar kinds of information from regulatory authorities in some of
the foreign countries where the Company conducts its global asset management
business.

The staff of the SEC has also informed the Company that it is considering
recommending a civil action or proceeding against Franklin Advisers and Franklin
Templeton Distributors, Inc. ("FTDI") concerning payments to securities dealers
who sell fund shares (commonly referred to as "revenue sharing"). The staff of
the California Attorney General's Office ("CAGO") also has advised the Company
that the California Attorney General is authorized to bring a civil action
against the Company and FTDI arising from the same events. Even though the
Company currently believes that the charges the SEC staff and CAGO staff are
contemplating are unwarranted, it also believes that it is in the best interest
of the Company's and funds' shareholders to resolve these issues voluntarily, to
the extent the Company can reasonably do so. The Company continues to have
discussions towards resolving these governmental investigations.

28 | Annual Report

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

9. REGULATORY MATTERS (CONTINUED)

OTHER LEGAL PROCEEDINGS

The Fund, in addition to other entities within Franklin Templeton Investments,
including the Company and certain of its subsidiaries, other funds, and current
and former officers, employees, and directors have been named in multiple
lawsuits in different federal courts in Nevada, California, Illinois, New York
and Florida, alleging violations of various federal securities laws and seeking,
among other things, monetary damages and costs. Specifically, the lawsuits claim
breach of duty with respect to alleged arrangements to permit market timing
and/or late trading activity, or breach of duty with respect to the valuation of
the portfolio securities of certain funds managed by Company subsidiaries,
resulting in alleged market timing activity. The majority of these lawsuits
duplicate, in whole or in part, the allegations asserted in the Massachusetts
administrative complaint described above. The lawsuits are styled as class
actions or derivative actions on behalf of either the named funds or the
Company.

Various subsidiaries of the Company have also been named in multiple lawsuits
filed in state courts in Illinois alleging breach of duty with respect to
valuation of the portfolio securities of certain funds managed by such
subsidiaries.

In addition, the Company and certain of its subsidiaries, as well as certain
current and former officers, employees, and directors have been named in
multiple lawsuits alleging violations of various securities laws and pendent
state law claims relating to the disclosure of directed brokerage payments
and/or payment of allegedly excessive advisory, commission, and distribution
fees. These lawsuits are styled as class actions and derivative actions brought
on behalf of certain funds.

The Company's management strongly believes that the claims made in each of these
lawsuits are without merit and intends to vigorously defend against them.

The Company cannot predict with certainty the eventual outcome of the foregoing
governmental investigations or class actions or other lawsuits. If the Company
finds that it bears responsibility for any unlawful or inappropriate conduct
that caused losses to the Fund, it is committed to making the Fund or its
shareholders whole, as appropriate.

Annual Report | 29

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

TO THE BOARD OF TRUSTEES AND SHAREHOLDERS OF FRANKLIN STRATEGIC MORTGAGE
PORTFOLIO

In our opinion, the accompanying statement of assets and liabilities, including
the statement of investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of Franklin Strategic Mortgage
Portfolio (the "Fund") at September 30, 2004, the results of its operations for
the year then ended, the changes in its net assets for each of the two years in
the period then ended and the financial highlights for each of the five years in
the period then ended, in conformity with accounting principles generally
accepted in the United States of America. These financial statements and
financial highlights (hereafter referred to as "financial statements") are the
responsibility of the Fund's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these financial statements in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits, which included
confirmation of securities at September 30, 2004 by correspondence with the
custodian, provide a reasonable basis for our opinion.

PricewaterhouseCoopers LLP

San Francisco, California
November 12, 2004

30 | Annual Report

BOARD MEMBERS AND OFFICERS

The name, age and address of the officers and board members, as well as their
affiliations, positions held with the Trust, principal occupations during the
past five years and number of portfolios overseen in the Franklin Templeton
Investments fund complex are shown below. Each board member will serve until
that person's successor is elected and qualified.

INDEPENDENT BOARD MEMBERS

- ------------------------------------------------------------------------------------------------------------------------------------
NUMBER OF PORTFOLIOS IN
LENGTH OF FUND COMPLEX OVERSEEN
NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------------------------------------------------------------------------------------------------------------------------

FRANK H. ABBOTT, III (83) Trustee Since 1992 111 None
One Franklin Parkway
San Mateo, CA 94403-1906
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
President and Director, Abbott Corporation (an investment company); and FORMERLY, Director, MotherLode Gold Mines Consolidated
(gold mining) (until 1996) and Vacu-Dry Co. (food processing) (until 1996).
- -----------------------------------------------------------------------------------------------------------------------------------
HARRIS J. ASHTON (72) Trustee Since 1992 140 Director, Bar-S Foods (meat
One Franklin Parkway packing company).
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director of various companies; and FORMERLY, Director, RBC Holdings, Inc. (bank holding company) (until 2002); and President,
Chief Executive Officer and Chairman of the Board, General Host Corporation (nursery and craft centers) (until 1998).
- ------------------------------------------------------------------------------------------------------------------------------------
S. JOSEPH FORTUNATO (72) Trustee Since 1992 141 None
One Franklin Parkway
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Attorney; and FORMERLY, member of the law firm of Pitney, Hardin, Kipp & Szuch.
- ------------------------------------------------------------------------------------------------------------------------------------
EDITH E. HOLIDAY (52) Trustee Since 2003 96 Director, Amerada Hess
One Franklin Parkway Corporation (exploration and
San Mateo, CA 94403-1906 refining of oil and gas); H.J.
Heinz Company (processed foods
and allied products); RTI
International Metals, Inc.
(manufacture and distribution of
titanium); and Canadian National
Railway (railroad).
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director or Trustee of various companies and trusts; and FORMERLY, Assistant to the President of the United States and Secretary
of the Cabinet (1990-1993); General Counsel to the United States Treasury Department (1989-1990); and Counselor to the Secretary
and Assistant Secretary for Public Affairs and Public Liaison-United States Treasury Department (1988-1989).
- ------------------------------------------------------------------------------------------------------------------------------------
FRANK W.T. LAHAYE (75) Trustee Since 1992 113 Director, The California Center
One Franklin Parkway for Land Recycling
San Mateo, CA 94403-1906 (redevelopment).
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
General Partner, Las Olas L.P. (Asset Management); and FORMERLY, Chairman, Peregrine Venture Management Company (venture capital).
- ------------------------------------------------------------------------------------------------------------------------------------

Annual Report | 31

GORDON S. MACKLIN (76) Trustee Since 1998 140 Director, White Mountains
One Franklin Parkway Insurance Group, Ltd. (holding
San Mateo, CA 94403-1906 company); Martek Biosciences
Corporation; MedImmune, Inc.
(biotechnology); and
Overstock.com (Internet
services); and FORMERLY,
Director, MCI Communication
Corporation (subsequently known
as MCI WorldCom, Inc. and
WorldCom, Inc.) (communications
services) (1988-2002) and
Spacehab, Inc. (aerospace
services) (1994-2003).
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Deputy Chairman, White Mountains Insurance Group, Ltd. (holding company); and FORMERLY, Chairman, White River Corporation (financial
services) (1993-1998) and Hambrecht & Quist Group (investment banking) (1987-1992); and President, National Association of
Securities Dealers, Inc. (1970-1987).
- ------------------------------------------------------------------------------------------------------------------------------------

INTERESTED BOARD MEMBERS AND OFFICERS

**HARMON E. BURNS (59) Trustee and Trustee since 36 None
One Franklin Parkway Vice President 1993 and Vice
San Mateo, CA 94403-1906 President since
1992
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice Chairman, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Vice President and Director, Franklin
Templeton Distributors, Inc.; Executive Vice President, Franklin Advisers, Inc.; Director, Franklin Investment Advisory Services,
Inc.; and officer and/or director or trustee, as the case may be, of some of the other subsidiaries of Franklin Resources, Inc. and
of 49 of the investment companies in Franklin Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------
**CHARLES B. JOHNSON (71) Trustee and Trustee since 1992 140 None
One Franklin Parkway Chairman of and Chairman of
San Mateo, CA 94403-1906 the Board the Board since
1993
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Chairman of the Board, Chief Executive Officer, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Vice
President, Franklin Templeton Distributors, Inc.; Director, Fiduciary Trust Company International; and officer and/or director or
trustee, as the case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 46 of the investment companies in
Franklin Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------

32 | Annual Report

**RUPERT H. JOHNSON, JR. (64) Trustee, Trustee since 123 None
One Franklin Parkway President 1992, President
San Mateo, CA 94403-1906 and Chief since 1993 and
Executive Chief Executive
Officer - Officer -
Investment Investment
Management Management
since 2002
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice Chairman, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Vice President and Director, Franklin
Templeton Distributors, Inc.; Director, Franklin Advisers, Inc. and Franklin Investment Advisory Services, Inc.; Senior Vice
President, Franklin Advisory Services, LLC; and officer and/or director or trustee, as the case may be, of some of the other
subsidiaries of Franklin Resources, Inc. and of 49 of the investment companies in Franklin Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------
JAMES M. DAVIS (52) Chief Since July 2004 Not Applicable None
One Franklin Parkway Compliance
San Mateo, CA 94403-1906 Officer
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Officer of 51 of the investment companies in Franklin Templeton Investments; Director, Global Compliance, Franklin Resources, Inc.,
and FORMERLY, Director of Compliance, Franklin Resources, Inc. (1994-2001).
- ------------------------------------------------------------------------------------------------------------------------------------
LAURA FERGERSON (42) Treasurer Since July 2004 Not Applicable None
One Franklin Parkway
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Officer of 34 of the investment companies in Franklin Templeton Investments; and FORMERLY, Director and member of Audit and
Valuation Committees, Runkel Funds, Inc. (2003-2004); Assistant Treasurer of most of the investment companies in Franklin Templeton
Investments (1997-2003); and Vice President, Franklin Templeton Services, LLC (1997-2003).
- ------------------------------------------------------------------------------------------------------------------------------------
MARTIN L. FLANAGAN (44) Vice President Since 1995 Not Applicable None
One Franklin Parkway
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Co-President and Chief Executive Officer, Franklin Resources, Inc.; Senior Vice President and Chief Financial Officer, Franklin
Mutual Advisers, LLC; Executive Vice President, Chief Financial Officer and Director, Templeton Worldwide, Inc.; Executive Vice
President and Chief Operating Officer, Templeton Investment Counsel, LLC; President and Director, Franklin Advisers, Inc.; Executive
Vice President, Franklin Investment Advisory Services, Inc. and Franklin Templeton Investor Services, LLC; Chief Financial Officer,
Franklin Advisory Services, LLC; Chairman, Franklin Templeton Services, LLC; and officer and/or director or trustee, as the case may
be, of some of the other subsidiaries of Franklin Resources, Inc. and of 49 of the investment companies in Franklin Templeton
Investments.
- ------------------------------------------------------------------------------------------------------------------------------------

Annual Report | 33

JIMMY D. GAMBILL (57) Senior Vice Since 2002 Not Applicable None
500 East Broward Blvd. President and
Suite 2100 Chief Executive
Fort Lauderdale, FL 33394-3091 Officer -
Finance and
Administration
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
President, Franklin Templeton Services, LLC, and officer of some of the investment companies in Franklin Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------
DAVID P. GOSS (57) Vice President Since 2000 Not Applicable None
One Franklin Parkway
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Associate General Counsel, Franklin Resources, Inc.; officer and director of one of the subsidiaries of Franklin Resources, Inc.;
officer of 51 of the investment companies in Franklin Templeton Investments; and FORMERLY, President, Chief Executive Officer and
Director, Property Resources Equity Trust (until 1999) and Franklin Select Realty Trust (until 2000).
- ------------------------------------------------------------------------------------------------------------------------------------
BARBARA J. GREEN (56) Vice President Since 2000 Not Applicable None
One Franklin Parkway
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice President, Deputy General Counsel and Secretary, Franklin Resources, Inc.; Secretary and Senior Vice President, Templeton
Worldwide, Inc.; Secretary, Franklin Advisers, Inc., Franklin Advisory Services, LLC, Franklin Investment Advisory Services, Inc.,
Franklin Mutual Advisers, LLC, Franklin Templeton Alternative Strategies, Inc., Franklin Templeton Investor Services, LLC, Franklin
Templeton Services, LLC, Franklin Templeton Distributors, Inc., Templeton Investment Counsel, LLC, and Templeton/Franklin Investment
Services, Inc.; and officer of some of the other subsidiaries of Franklin Resources, Inc. and of 51 of the investment companies in
Franklin Templeton Investments; and FORMERLY, Deputy Director, Division of Investment Management, Executive Assistant and Senior
Advisor to the Chairman, Counselor to the Chairman, Special Counsel and Attorney Fellow, U.S. Securities and Exchange Commission
(1986-1995); Attorney, Rogers & Wells (until 1986); and Judicial Clerk, U.S. District Court (District of Massachusetts) (until
1979).
- ------------------------------------------------------------------------------------------------------------------------------------
MICHAEL O. MAGDOL (67) Vice President Since 2002 Not Applicable Director, FTI Banque, Arch
600 Fifth Avenue - AML Chemicals, Inc. and Lingnan
Rockefeller Center Compliance Foundation.
New York, NY 10020-2302
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice Chairman, Chief Banking Officer and Director, Fiduciary Trust Company International; and officer and/or director, as the
case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 48 of the investment companies in Franklin
Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------

34 | Annual Report

MURRAY L. SIMPSON (67) Vice President Since 2000 Not Applicable None
One Franklin Parkway and Secretary
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Executive Vice President and General Counsel, Franklin Resources, Inc.; officer and/or director, as the case may be, of some of the
subsidiaries of Franklin Resources, Inc. and of 51 of the investment companies in Franklin Templeton Investments; and FORMERLY,
Chief Executive Officer and Managing Director, Templeton Franklin Investment Services (Asia) Limited (until 2000); and Director,
Templeton Asset Management Ltd. (until 1999).
- ------------------------------------------------------------------------------------------------------------------------------------
GALEN G. VETTER (52) Chief Financial Since May 2004 Not Applicable None
500 East Broward Blvd. Officer and
Suite 2100 Chief
Fort Lauderdale, FL 33394-3091 Accounting
Officer
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Officer of 51 of the investment companies in Franklin Templeton Investments; Senior Vice President, Franklin Templeton Services,
LLC; and FORMERLY, Managing Director, RSM McGladrey, Inc.; and Partner, McGladrey & Pullen, LLP.
- ------------------------------------------------------------------------------------------------------------------------------------

* We base the number of portfolios on each separate series of the U.S.
registered investment companies within the Franklin Templeton Investments
fund complex. These portfolios have a common investment adviser or
affiliated investment advisers.

** Charles B. Johnson and Rupert H. Johnson, Jr. are considered to be
interested persons of the Trust under the federal securities laws due to
their positions as officers and directors and major shareholders of
Franklin Resources, Inc. (Resources), which is the parent company of the
Trust's adviser and distributor. Harmon E. Burns is considered to be an
interested person of the Trust under the federal securities laws due to
his position as officer and director of Resources.

Note: Charles B. Johnson and Rupert H. Johnson, Jr. are brothers.

THE SARBANES-OXLEY ACT OF 2002 AND RULES ADOPTED BY THE SECURITIES AND EXCHANGE
COMMISSION REQUIRE THE FUND TO DISCLOSE WHETHER THE FUND'S AUDIT COMMITTEE
INCLUDES AT LEAST ONE MEMBER WHO IS AN AUDIT COMMITTEE FINANCIAL EXPERT WITHIN
THE MEANING OF SUCH ACT AND RULES. THE FUND'S BOARD OF TRUSTEES HAS DETERMINED
THAT THERE IS AT LEAST ONE SUCH FINANCIAL EXPERT ON THE AUDIT COMMITTEE AND HAS
DESIGNATED FRANK W.T. LAHAYE AS ITS AUDIT COMMITTEE FINANCIAL EXPERT. THE BOARD
BELIEVES THAT MR. LAHAYE QUALIFIES AS SUCH AN EXPERT IN VIEW OF HIS EXTENSIVE
BUSINESS BACKGROUND AND EXPERIENCE, INCLUDING SERVICE AS PRESIDENT AND DIRECTOR
OF MCCORMICK SELPH ASSOCIATES FROM 1954 THROUGH 1965; DIRECTOR AND CHAIRMAN OF
TELEDYNE CANADA LTD. FROM 1966 THROUGH 1971; DIRECTOR AND CHAIRMAN OF
QUARTERDECK CORPORATION FROM 1982 THROUGH 1998; AND SERVICES AS A DIRECTOR OF
VARIOUS OTHER PUBLIC COMPANIES INCLUDING U.S. TELEPHONE INC. (1981-1984), FISHER
IMAGING INC. (1991-1998) AND DIGITAL TRANSMISSIONS SYSTEMS (1995-1999). IN
ADDITION, MR. LAHAYE SERVED FROM 1981 TO 2000 AS A DIRECTOR AND CHAIRMAN OF
PEREGRINE VENTURE MANAGEMENT CO., A VENTURE CAPITAL FIRM, AND HAS BEEN A MEMBER
AND CHAIRMAN OF THE FUND'S AUDIT COMMITTEE SINCE ITS INCEPTION. AS A RESULT OF
SUCH BACKGROUND AND EXPERIENCE, THE BOARD OF TRUSTEES BELIEVES THAT MR. LAHAYE
HAS ACQUIRED AN UNDERSTANDING OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND
FINANCIAL STATEMENTS, THE GENERAL APPLICATION OF SUCH PRINCIPLES IN CONNECTION
WITH THE ACCOUNTING ESTIMATES, ACCRUALS AND RESERVES, AND ANALYZING AND
EVALUATING FINANCIAL STATEMENTS THAT PRESENT A BREADTH AND LEVEL OF COMPLEXITY
OF ACCOUNTING ISSUES GENERALLY COMPARABLE TO THOSE OF THE FUND, AS WELL AS AN
UNDERSTANDING OF INTERNAL CONTROLS AND PROCEDURES FOR FINANCIAL REPORTING AND AN
UNDERSTANDING OF AUDIT COMMITTEE FUNCTIONS. MR. LAHAYE IS AN INDEPENDENT TRUSTEE
AS THAT TERM IS DEFINED UNDER THE RELEVANT SECURITIES AND EXCHANGE COMMISSION
RULES AND RELEASES.

THE STATEMENT OF ADDITIONAL INFORMATION (SAI) INCLUDES ADDITIONAL INFORMATION
ABOUT THE BOARD MEMBERS AND IS AVAILABLE, WITHOUT CHARGE, UPON REQUEST.
SHAREHOLDERS MAY CALL 1-800/DIAL BEN (1-800/342-5236) TO REQUEST THE SAI.

Annual Report | 35

FRANKLIN STRATEGIC MORTGAGE PORTFOLIO

SHAREHOLDER INFORMATION

PROXY VOTING POLICIES AND PROCEDURES

The Fund has established Proxy Voting Policies and Procedures ("Policies") that
the Fund uses to determine how to vote proxies relating to portfolio securities.
Shareholders may view the Fund's complete Policies online at
franklintempleton.com. Alternatively, shareholders may request copies of the
Policies free of charge by calling the Proxy Group collect at 1-954/847-2268 or
by sending a written request to: Franklin Templeton Companies, LLC, 500 East
Broward Boulevard, Suite 1500, Fort Lauderdale, FL 33394, Attention: Proxy
Group. Copies of the Fund's proxy voting records are also made available online
at franklintempleton.com and posted on the Securities and Exchange Commission's
website at sec.gov and reflect the 12-month period beginning July 1, 2003, and
ending June 30, 2004.

QUARTERLY STATEMENT OF INVESTMENTS

The Fund files a complete statement of investments with the Securities and
Exchange Commission for the first and third quarters for each fiscal year on
Form N-Q. Shareholders may view the filed Form N-Q by visiting the Commission's
website at sec.gov. The filed form may also be viewed and copied at the
Commission's Public Reference Room in Washington, DC. Information regarding the
operations of the Public Reference Room may be obtained by calling
1-800/SEC-0330.

36 | Annual Report

LITERATURE REQUEST

TO RECEIVE A BROCHURE AND PROSPECTUS, PLEASE CALL US AT 1-800/DIAL BEN(R)
(1-800/342-5236) OR VISIT FRANKLINTEMPLETON.COM. INVESTORS SHOULD CAREFULLY
CONSIDER A FUND'S INVESTMENT GOALS, RISKS, CHARGES AND EXPENSES BEFORE
INVESTING. THE PROSPECTUS CONTAINS THIS AND OTHER INFORMATION. PLEASE CAREFULLY
READ THE PROSPECTUS BEFORE INVESTING. TO ENSURE THE HIGHEST QUALITY OF SERVICE,
WE MAY MONITOR, RECORD AND ACCESS TELEPHONE CALLS TO OR FROM OUR SERVICE
DEPARTMENTS. THESE CALLS CAN BE IDENTIFIED BY THE PRESENCE OF A REGULAR BEEPING
TONE.

FRANKLIN TEMPLETON INVESTMENTS

INTERNATIONAL

Mutual European Fund
Templeton China World Fund
Templeton Developing Markets Trust
Templeton Foreign Fund
Templeton Foreign Smaller Companies Fund
Templeton International (Ex EM) Fund

GLOBAL

Mutual Discovery Fund
Templeton Capital Accumulator Fund
Templeton Global Long-Short Fund
Templeton Global Opportunities Trust
Templeton Global Smaller Companies Fund
Templeton Growth Fund
Templeton World Fund

GROWTH

Franklin Aggressive Growth Fund
Franklin Capital Growth Fund
Franklin Flex Cap Growth Fund
Franklin Small Cap Growth Fund II(1)
Franklin Small-Mid Cap Growth Fund

VALUE

Franklin Balance Sheet
Investment Fund(2)
Franklin Equity Income Fund
Franklin Large Cap Value Fund
Franklin MicroCap Value Fund(2)
Franklin Small Cap Value Fund
Mutual Beacon Fund
Mutual Qualified Fund
Mutual Recovery Fund(3)
Mutual Shares Fund

BLEND

Franklin Blue Chip Fund
Franklin Convertible Securities Fund
Franklin Growth Fund
Franklin Rising Dividends Fund
Franklin U.S. Long-Short Fund(4)

SECTOR

Franklin Biotechnology Discovery Fund
Franklin DynaTech Fund
Franklin Global Communications Fund
Franklin Global Health Care Fund
Franklin Gold and Precious Metals Fund
Franklin Natural Resources Fund
Franklin Real Estate Securities Fund
Franklin Technology Fund
Franklin Utilities Fund
Mutual Financial Services Fund

ASSET ALLOCATION

Franklin Templeton Corefolio
Allocation Fund
Franklin Templeton Founding Funds
Allocation Fund
Franklin Templeton Perspectives
Allocation Fund

TARGET FUNDS

Franklin Templeton Conservative Target Fund
Franklin Templeton Growth Target Fund
Franklin Templeton Moderate Target Fund

INCOME

Franklin Adjustable U.S. Government
Securities Fund(5)
Franklin's AGE High Income Fund
Franklin Federal Money Fund(5), (6)
Franklin Floating Rate Daily Access Fund
Franklin Floating Rate Trust(3)
Franklin Income Fund
Franklin Limited Maturity
U.S. Government Securities Fund(5), (7)
Franklin Money Fund(5), (6)
Franklin Strategic Income Fund
Franklin Strategic Mortgage Portfolio
Franklin Templeton Hard Currency Fund
Franklin Total Return Fund
Franklin U.S. Government Securities Fund(5)
Templeton Global Bond Fund

TAX-FREE INCOME(8)

NATIONAL FUNDS

Double Tax-Free Income Fund
Federal Tax-Free Income Fund
High Yield Tax-Free Income Fund
Insured Tax-Free Income Fund(9)
Tax-Exempt Money Fund(5), (6)

LIMITED-TERM FUNDS

California Limited-Term Tax-Free Income Fund
Federal Limited-Term Tax-Free Income Fund
New York Limited-Term Tax-Free Income Fund

INTERMEDIATE-TERM FUNDS

California Intermediate-Term
Tax-Free Income Fund
Federal Intermediate-Term
Tax-Free Income Fund
New York Intermediate-Term
Tax-Free Income Fund

STATE-SPECIFIC

Alabama
Arizona
California(10)
Colorado
Connecticut
Florida(10)
Georgia
Kentucky
Louisiana
Maryland
Massachusetts(9)
Michigan(9)
Minnesota(9)
Missouri
New Jersey
New York(10)
North Carolina
Ohio(9)
Oregon
Pennsylvania
Tennessee
Virginia

INSURANCE FUNDS

Franklin Templeton Variable Insurance
Products Trust(11)

(1) The fund is closed to new investors. Existing shareholders can continue
adding to their accounts.

(2) The fund is only open to existing shareholders and select retirement
plans.

(3) The fund is a continuously offered, closed-end fund. Shares may be
purchased daily; there is no daily redemption. However, each quarter,
pending board approval, the fund will authorize the repurchase of 5%-25%
of the outstanding number of shares. Investors may tender all or a portion
of their shares during the tender period.

(4) Upon reaching approximately $350 million in assets, the fund intends to
close to all investors.

(5) An investment in the fund is neither insured nor guaranteed by the U.S.
government or by any other entity or institution.

(6) Although the fund seeks to preserve the value of your investment at $1.00
per share, it is possible to lose money by investing in the fund.

(7) Formerly Franklin Short-Intermediate U.S. Government Securities Fund.
Effective 9/1/04, the fund's name changed; its investment goal and
strategy remained the same.

(8) For investors subject to the alternative minimum tax, a small portion of
fund dividends may be taxable. Distributions of capital gains are
generally taxable.

(9) Portfolio of insured municipal securities.

(10) These funds are available in two or more variations, including long-term
portfolios, portfolios of insured securities, a high-yield portfolio (CA)
and limited-term, intermediate-term and money market portfolios (CA and
NY).

(11) The funds of the Franklin Templeton Variable Insurance Products Trust are
generally available only through insurance company variable contracts.

09/04 Not part of the annual report

[LOGO](R)
FRANKLIN(R) TEMPLETON(R) One Franklin Parkway
INVESTMENTS San Mateo, CA 94403-1906

|_| WANT TO RECEIVE THIS DOCUMENT FASTER VIA EMAIL?

Eligible shareholders can sign up for eDelivery at franklintempleton.com.
See inside for details.

ANNUAL REPORT AND SHAREHOLDER LETTER

FRANKLIN STRATEGIC
MORTGAGE PORTFOLIO

INVESTMENT MANAGER

Franklin Advisers, Inc.

DISTRIBUTOR

Franklin Templeton Distributors, Inc.
1-800/DIAL BEN(R)
franklintempleton.com

SHAREHOLDER SERVICES

1-800/632-2301

Authorized for distribution only when accompanied or preceded by a prospectus.
Investors should carefully consider a fund's investment goals, risks, charges
and expenses before investing. The prospectus contains this and other
information; please read it carefully before investing.

To ensure the highest quality of service, telephone calls to or from our service
departments may be monitored, recorded and accessed. These calls can be
identified by the presence of a regular beeping tone.

157 A2004 11/04

ITEM 2. CODE OF ETHICS.

(a) The Registrant has adopted a code of ethics that applies to its principal
executive officers and principal financial and accounting officer.

(d) N/A

(f) Pursuant to Item 11(A), the Registrant is attaching as an exhibit a copy of
its code of ethics that applies to its principal executive officers and
principal financial and accounting officer.

ITEM 3. AUDIT COMMITTEE FINANCIAL EXPERT.

(a)(1) The Registrant has an audit committee financial expert serving on its
audit committee.

(2) The audit committee financial expert is Frank W. T. LaHaye and he is
"independent" as defined under the relevant Securities and Exchange Commission
Rules and Releases.

ITEM 4. PRINCIPAL ACCOUNTANT FEES AND SERVICES.

(a) Audit Fees
The aggregate fees paid to the principal accountant for professional services
rendered by the principal accountant for the audit of the registrant's annual
financial statements or for services that are normally provided by the principal
accountant in connection with statutory and regulatory filings or engagements
were $19,163 for the fiscal year ended September 30, 2004 and $16,689 for the
fiscal year ended September 30, 2003.

(b) Audit-Related Fees
There were no fees paid to the principal accountant for assurance and related
services rendered by the principal accountant to the registrant that are
reasonably related to the performance of the audit of the registrant's financial
statements and are not reported under paragraph (a) of Item 4.

The aggregate fees paid to the principal accountant for assurance and related
services rendered by the principal accountant to the registrant's investment
adviser and any entity controlling, controlled by or under common control with
the investment adviser that provides ongoing services to the registrant that are
reasonably related to the performance of the audit of the their financial
statements were $48,619 for the fiscal year ended September 30, 2004 and $3,619
for the fiscal year ended September 30, 2003. The services for which these fees
were paid included attestation services.

(c) Tax Fees
There were no fees paid to the principal accountant for professional services
rendered by the principal accountant to the registrant for tax compliance, tax
advice and tax planning.

There were no fees paid to the principal accountant for professional services
rendered by the principal accountant to the registrant's investment adviser and
any entity controlling, controlled by or under common control with the
investment adviser that provides ongoing services to the registrant for tax
compliance, tax advice and tax planning.

(d) All Other Fees
The aggregate fees paid to the principal accountant for products and services
rendered by the principal accountant to the registrant not reported in
paragraphs (a)-(c) of Item 4 were $213 for the fiscal year ended September 30,
2004 and $0 for the fiscal year ended September 30, 2003. The services for which
these fees were paid included review of materials provided to the fund Board in
connection with the investment management contract renewal process.

The aggregate fees paid to the principal accountant for products and services
rendered by the principal accountant to the registrant's investment adviser and
any entity controlling, controlled by or under common control with the
investment adviser that provides ongoing services to the registrant not reported
in paragraphs (a)-(c) of Item 4 were $99,787 for the fiscal year ended September
30, 2004 and $12,000 for the fiscal year ended September 30, 2003. The services
for which these fees were paid included review of materials provided to the fund
Board in connection with the investment management contract renewal process and
a review of an ICI transfer agent survey.

(e) (1) The registrant's audit committee is directly responsible for approving
the services to be provided by the auditors, including:

(i) pre-approval of all audit and audit related services;

(ii) pre-approval of all non-audit related services to be provided to the
Fund by the auditors;

(iii)pre-approval of all non-audit related services to be provided to the
registrant by the auditors to the registrant's investment adviser or to any
entity that controls, is controlled by or is under common control with the
registrant's investment adviser and that provides ongoing services to the
registrant where the non-audit services relate directly to the operations or
financial reporting of the registrant; and

(iv) establishment by the audit committee, if deemed necessary or
appropriate, as an alternative to committee pre-approval of services to be
provided by the auditors, as required by paragraphs (ii) and (iii) above, of
policies and procedures to permit such services to be pre-approved by other
means, such as through establishment of guidelines or by action of a designated
member or members of the committee; provided the policies and procedures are
detailed as to the particular service and the committee is informed of each
service and such policies and procedures do not include delegation of audit
committee responsibilities, as contemplated under the Securities Exchange Act of
1934, to management; subject, in the case of (ii) through (iv), to any waivers,
exceptions or exemptions that may be available under applicable law or rules.

(e) (2) None of the services provided to the registrant described in paragraphs
(b)-(d) of Item 4 were pre-approved by the audit committee pursuant to paragraph
(c)(7)(i)(C) of Rule 2-01 of regulation S-X.

(f) No disclosures are required by this Item 4(f).

(g) The aggregate non-audit fees paid to the principal accountant for services
rendered by the principal accountant to the registrant and the registrant's
investment adviser and any entity controlling, controlled by or under common
control with the investment adviser that provides ongoing services to the
registrant were $148,619 for the fiscal year ended September 30, 2004 and
$15,619 for the fiscal year ended September 30, 2003.

(h) No disclosures are required by this Item 4(h).

ITEM 5. AUDIT COMMITTEE OF LISTED REGISTRANTS. N/A

ITEM 6. SCHEDULE OF INVESTMENTS. N/A

ITEM 7. DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES
FOR CLOSED-END MANAGEMENT INVESTMENT COMPANIES. N/A

ITEM 8. PURCHASES OF EQUITY SECURITIES BY CLOSED-END
MANAGEMENT INVESTMENT COMPANY AND AFFILIATED PURCHASERS. N/A

ITEM 9. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There have
been no changes to the procedures by which shareholders may recommend nominees
to the Registrant's Board of Trustees that would require disclosure herein.

ITEM 10. CONTROLS AND PROCEDURES. (A) EVALUATION OF DISCLOSURE CONTROLS
AND PROCEDURES. The Registrant maintains disclosure controls and procedures that
are designed to ensure that information required to be disclosed in the
Registrant's filings under the Securities Exchange Act of 1934 and the
Investment Company Act of 1940 is recorded, processed, summarized and reported
within the periods specified in the rules and forms of the Securities and
Exchange Commission. Such information is accumulated and communicated to the
Registrant's management, including its principal executive officer and principal
financial officer, as appropriate, to allow timely decisions regarding required
disclosure. The Registrant's management, including the principal executive
officer and the principal financial officer, recognizes that any set of controls
and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives.

Within 90 days prior to the filing date of this Shareholder Report on Form
N-CSR, the Registrant had carried out an evaluation, under the supervision and
with the participation of the Registrant's management, including the
Registrant's principal executive officer and the Registrant's principal
financial officer, of the effectiveness of the design and operation of the
Registrant's disclosure controls and procedures. Based on such evaluation, the
Registrant's principal executive officer and principal financial officer
concluded that the Registrant's disclosure controls and procedures are
effective.

(B) CHANGES IN INTERNAL CONTROLS. There have been no significant changes in the
Registrant's internal controls or in other factors that could significantly
affect the internal controls subsequent to the date of their evaluation in
connection with the preparation of this Shareholder Report on Form N-CSR.

ITEM 11. EXHIBITS.

(A) Code of Ethics

(B) (1) Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
of Jimmy D. Gambill, Chief Executive Officer - Finance and Administration, and
Galen G. Vetter, Chief Financial Officer

(B) (2) Certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
of Jimmy D. Gambill, Chief Executive Officer - Finance and Administration, and
Galen G. Vetter, Chief Financial Officer

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.

FRANKLIN STRATEGIC MORTGAGE PROTFOLIO

By /s/Jimmy D. Gambill
Chief Executive Officer - Finance and Administration
Date November 29, 2004

Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.

By /s/Jimmy D. Gambill
Chief Executive Officer - Finance and Administration
Date November 29, 2004

By /s/Galen G. Vetter
Chief Financial Officer
Date November 29, 2004