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
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(Exact name of registrant as specified in charter)
ONE FRANKLIN PARKWAY, SAN MATEO, CA 94403-1906
(Address of principal executive offices) (Zip code)
CRAIG S. TYLE, 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: 9/30
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Date of reporting period: 9/30/05
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ITEM 1. REPORTS TO STOCKHOLDERS.
[GRAPHIC OMITTED]
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SEPTEMBER 30, 2005
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ANNUAL REPORT AND SHAREHOLDER LETTER INCOME
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WANT TO RECEIVE
THIS DOCUMENT
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FRANKLIN
STRATEGIC MORTGAGE PORTFOLIO Eligible shareholders can
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See inside for details.
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[LOGO](R)
FRANKLIN TEMPLETON
INVESTMENTS
Franklin Templeton Mutual Series
FRANKLIN TEMPLETON INVESTMENTS
GAIN FROM OUR PERSPECTIVE(R)
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 offices in over 25 countries, Templeton offers
investors a truly global perspective.
MUTUAL SERIES. Founded in 1949, Mutual Series is
dedicated to a unique style of value investing,
searching aggressively for opportunity among what it
believes are undervalued stocks, as well as
arbitrage situations and distressed securities.
TRUE DIVERSIFICATION Because our management groups work independently and
adhere to different investment approaches, Franklin,
Templeton and Mutual Series funds typically have
distinct portfolios. That's why our funds can be
used to build truly diversified allocation plans
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, accurate and personal service that has
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 ..................................... 4
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 ........................................................... 29
Board Members and Officers ................................................ 30
Shareholder Information ................................................... 35
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ANNUAL REPORT
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
YOUR FUND'S GOAL AND MAIN INVESTMENTS: Franklin Strategic Mortgage Portfolio
seeks high 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 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, 2005.
PERFORMANCE OVERVIEW
For the year under review, Franklin Strategic Mortgage Portfolio - Class A
delivered a +2.74% cumulative total return. The Fund underperformed its
benchmark, the Citigroup Mortgage Index, which returned +3.33% for the same
period.(2) For comparison, the Lipper U.S. Mortgage Funds Classification Average
returned +2.46%, and the Lehman Brothers U.S. Treasury Index, a
(1) Securities owned by the Fund 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 for government agency or instrumentality
securities. The Fund's 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 179 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.
4 | Annual Report
component of the Lehman Brothers U.S. Government Index, returned +2.48%.(3) You
can find the Fund's long-term performance data in the Performance Summary on
page 8.
ECONOMIC AND MARKET OVERVIEW
Overall domestic economic growth remained healthy during the reporting period.
More than two-thirds of U.S. gross domestic product (GDP) is generated by
consumer spending and almost one-fifth by business spending. Since consumer
spending relies on consumers' ability to remain gainfully employed, many
analysts study the employment picture for indications of consumer spending. Over
the past year, nonfarm payroll data, as well as other indexes, showed growing
employment. This along with other factors helped consumer spending increase 6.7%
(not adjusted for inflation) in September 2005 compared with the same month a
year earlier, which supported U.S. economic growth.(4)
Business spending also rose during the reporting period, contributing to
economic growth. Nonresidential investment spending rose in each of the past
year's four quarters, resulting in 7.8% growth for the year under review.4
Historically low interest rates continued to allow many companies easy access to
capital, and ample cash also helped some companies to support their spending
plans. Productivity continued to grow, which helped businesses generate more
goods and services without substantially raising inflation.
(3) Sources: Lipper Inc.; Standard & Poor's Micropal. The Lipper U.S. Mortgage
Funds Classification 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 six-month period
ended 9/30/05, the Lipper U.S. Mortgage Funds Classification Average
consisted of 77 funds. Lipper calculations do not include sales charges.
The Fund's performance relative to the average might 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-Protected 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 Economic Analysis.
PORTFOLIO BREAKDOWN
9/30/05
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% OF TOTAL
NET ASSETS*
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Federal National Mortgage Association
(FNMA) 38.4%
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Federal Home Loan Mortgage Corp.
(FHLMC) 35.7%
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Asset-Backed Securities and Commercial
Mortgage-Backed Securities 19.9%
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Government National Mortgage
Association (GNMA) 15.2%
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Short-Term Investments 2.7%
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* Other net assets = -11.9% due to liabilities for forward settlements.
Annual Report | 5
DIVIDEND DISTRIBUTIONS*
10/1/04-9/30/05
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MONTH DIVIDEND PER SHARE
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October 4.1471 cents
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November 4.4582 cents
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December 4.1089 cents
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January 4.0428 cents
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February 4.0573 cents
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March 4.0825 cents
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April 3.9620 cents
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May 4.3753 cents
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June 4.2580 cents
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July 3.8951 cents
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August 4.4035 cents
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September 4.0391 cents
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TOTAL 49.8298 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
during the month. All Fund distributions will vary depending upon current
market conditions, and past distributions are not indicative of future
trends.
Oil prices increased substantially during the period amid concerns about
potential long-term supply limitations in the face of expected strong global
demand growth, especially from China and India. Despite rising commodity prices,
inflation remained relatively contained for the 12 months ended September 30,
2005, as measured by the 2.0% rise for the core Consumer Price Index (CPI).(5)
This increase was below the core CPI's 10-year average of 2.2%.(5) However,
acknowledging the economy's strength as well as potential inflationary pressure
from high energy prices, the Federal Reserve Board (Fed) raised the federal
funds target rate to 3.75% from 1.75% during the 12-month period and indicated
possible "measured" increases would follow. The Fed also noted in its most
recent statement that there would be some temporary economic effects due to
hurricane impacts, but there was some debate about the long-term effects. During
the period, the yield curve flattened, as short- and intermediate-term Treasury
yields rose and longer-term yields fell.
INVESTMENT STRATEGY
We invest at least 80% of the Fund's net assets in mortgage securities. Normally
we focus on mortgage pass-through securities issued or guaranteed by the
Government National Mortgage Association (Ginnie Mae), Fannie Mae and Freddie
Mac. At least 65% of total assets are invested in securities rated AAA by
Standard & Poor's (S&P) Rating Group or Aaa by Moody's Investors Service
(Moody's), independent credit rating agencies. The remaining 35% of 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
Our research shows that over the past 5-, 10- and 15-year time periods,
mortgage-backed securities (MBS), agency debentures and mortgage-related asset
backed securities (ABS) have offered attractive risk-adjusted returns when
compared with a variety of asset classes including U.S. Treasuries, investment
grade and high yield corporate bonds, and large and small capitalization stocks.
These time periods include various credit, prepayment, economic and interest
rate cycles. Generally speaking, the sectors in which the Fund invests tend to
outperform comparable maturity Treasuries during rising interest rate
environments because of their higher income and lower durations, or price
sensitivity to interest rate changes.
(5) Source: Bureau of Labor Statistics. Core CPI excludes food and energy
costs.
6 | Annual Report
Over the past several years, we have evolved our investment process to keep pace
with MBS market changes. Increasingly, bond dealers in the mortgage markets have
maximized and exercised settlement delivery options. This decreased the
attractiveness of the To Be Announced (TBA) market, and we increased our focus
and research on specified MBS pools.(6) Specified pools are securities with
enough distinct risk exposures to create market demands for a premium or
discount from TBA prices.
Using improved technologies, we seek to cull the daily opportunity set of MBS
specified pool sectors by running them through our relative valuation research
filters. We believe this can help position us ahead of other investors accessing
the MBS market.
We also looked for value within the hybrid adjustable-rate mortgage-backed
securities marketplace. These securities have a fixed rate for a set period of
time, and once the period ends, the rate floats to a given interest rate. As
their issuance increases, such securities are becoming an increasingly important
sector of the MBS marketplace.
Thank you for your continued participation in Franklin Strategic Mortgage
Portfolio. We look forward to serving your future investment needs.
[PHOTO] /s/ Roger A. Bayston,
Roger A. Bayston,
CFA Portfolio Manager
Franklin Strategic Mortgage Portfolio
(6) A TBA security consists of generic mortgage pools to be determined at the
settlement date. A specified pool consists of previously identified
mortgage pools.
THE FOREGOING INFORMATION REFLECTS OUR ANALYSIS, OPINIONS AND PORTFOLIO HOLDINGS
AS OF SEPTEMBER 30, 2005, 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 9/30/05
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 reinvestment of the Fund's dividends and
capital gain distributions, if any, and any unrealized gains or losses.
PRICE AND DISTRIBUTION INFORMATION
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CLASS A (SYMBOL: FSMIX) CHANGE 9/30/05 9/30/04
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Net Asset Value (NAV) -$0.23 $9.73 $9.96
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DISTRIBUTIONS (10/1/04-9/30/05)
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Dividend Income $0.498298
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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.
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CLASS A 1-YEAR 5-YEAR 10-YEAR
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Cumulative Total Return(2) +2.74% +34.62% +87.01%
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Average Annual Total Return(3) -1.61% +5.22% +6.00%
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Distribution Rate(4) 4.84%
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30-Day Standardized Yield(5) 3.83%
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PERFORMANCE DATA 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 applicable 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.
AVERAGE ANNUAL TOTAL RETURN
- ---------------------------------------------
CLASS A 9/30/05
- ---------------------------------------------
1-Year -1.61%
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5-Year +5.22%
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10-Year +6.00%
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CLASS A (10/1/95-9/30/05)
[THE FOLLOWING TABLE WAS REPRESENTED BY A LINE GRAPH IN THE PRINTED MATERIAL.]
Franklin
Strategic Citigroup
Mortgage Mortgage
Portfolio Index(6)
---------------------------------------------------
10/1/1995 $9,575 $10,000
10/31/1995 $9,674 $9,915
11/30/1995 $9,779 $10,210
12/31/1995 $9,893 $10,337
1/31/1996 $9,975 $10,416
2/29/1996 $9,896 $10,333
3/31/1996 $9,852 $10,298
4/30/1996 $9,827 $10,251
5/31/1996 $9,796 $10,237
6/30/1996 $9,911 $10,368
7/31/1996 $9,957 $10,409
8/31/1996 $9,954 $10,411
9/30/1996 $10,119 $10,586
10/31/1996 $10,316 $10,792
11/30/1996 $10,460 $10,940
12/31/1996 $10,419 $10,892
1/31/1997 $10,492 $10,984
2/28/1997 $10,511 $10,996
3/31/1997 $10,473 $10,905
4/30/1997 $10,623 $11,071
5/31/1997 $10,716 $11,174
6/30/1997 $10,824 $11,303
7/31/1997 $10,997 $11,512
8/31/1997 $10,990 $11,492
9/30/1997 $11,115 $11,629
10/31/1997 $11,223 $11,754
11/30/1997 $11,251 $11,793
12/31/1997 $11,356 $11,901
1/31/1998 $11,462 $12,012
2/28/1998 $11,489 $12,049
3/31/1998 $11,530 $12,096
4/30/1998 $11,588 $12,164
5/31/1998 $11,671 $12,249
6/30/1998 $11,738 $12,303
7/31/1998 $11,791 $12,364
8/31/1998 $11,913 $12,476
9/30/1998 $12,083 $12,625
10/31/1998 $12,085 $12,611
11/30/1998 $12,160 $12,670
12/31/1998 $12,213 $12,733
1/31/1999 $12,285 $12,821
2/28/1999 $12,224 $12,773
3/31/1999 $12,294 $12,861
4/30/1999 $12,347 $12,925
5/31/1999 $12,266 $12,838
6/30/1999 $12,234 $12,808
7/31/1999 $12,162 $12,721
8/31/1999 $12,154 $12,713
9/30/1999 $12,361 $12,930
10/31/1999 $12,416 $12,998
11/30/1999 $12,427 $13,009
12/31/1999 $12,395 $12,967
1/31/2000 $12,298 $12,867
2/29/2000 $12,436 $13,019
3/31/2000 $12,562 $13,158
4/30/2000 $12,580 $13,164
5/31/2000 $12,592 $13,175
6/30/2000 $12,854 $13,460
7/31/2000 $12,942 $13,545
8/31/2000 $13,142 $13,745
9/30/2000 $13,301 $13,892
10/31/2000 $13,400 $13,995
11/30/2000 $13,604 $14,203
12/31/2000 $13,874 $14,430
1/31/2001 $14,072 $14,654
2/28/2001 $14,154 $14,735
3/31/2001 $14,249 $14,831
4/30/2001 $14,263 $14,846
5/31/2001 $14,345 $14,938
6/30/2001 $14,405 $14,959
7/31/2001 $14,647 $15,238
8/31/2001 $14,772 $15,376
9/30/2001 $14,977 $15,603
10/31/2001 $15,170 $15,815
11/30/2001 $15,077 $15,670
12/31/2001 $15,035 $15,613
1/31/2002 $15,173 $15,767
2/28/2002 $15,323 $15,939
3/31/2002 $15,164 $15,778
4/30/2002 $15,462 $16,072
5/31/2002 $15,571 $16,190
6/30/2002 $15,706 $16,321
7/31/2002 $15,892 $16,505
8/31/2002 $16,009 $16,650
9/30/2002 $16,144 $16,771
10/31/2002 $16,198 $16,835
11/30/2002 $16,194 $16,819
12/31/2002 $16,365 $16,996
1/31/2003 $16,404 $17,044
2/28/2003 $16,504 $17,161
3/31/2003 $16,523 $17,156
4/30/2003 $16,592 $17,221
5/31/2003 $16,631 $17,229
6/30/2003 $16,645 $17,266
7/31/2003 $16,327 $16,954
8/31/2003 $16,432 $17,065
9/30/2003 $16,693 $17,357
10/31/2003 $16,617 $17,298
11/30/2003 $16,671 $17,348
12/31/2003 $16,837 $17,518
1/31/2004 $16,946 $17,629
2/29/2004 $17,106 $17,782
3/31/2004 $17,153 $17,860
4/30/2004 $16,904 $17,546
5/31/2004 $16,871 $17,490
6/30/2004 $16,994 $17,641
7/31/2004 $17,121 $17,807
8/31/2004 $17,407 $18,100
9/30/2004 $17,429 $18,125
10/31/2004 $17,554 $18,280
11/30/2004 $17,509 $18,226
12/31/2004 $17,599 $18,360
1/31/2005 $17,689 $18,453
2/28/2005 $17,636 $18,374
3/31/2005 $17,584 $18,324
4/30/2005 $17,763 $18,541
5/31/2005 $17,914 $18,690
6/30/2005 $17,955 $18,755
7/31/2005 $17,862 $18,667
8/31/2005 $18,033 $18,833
9/30/2005 $17,906 $18,729
Total Return 79.06% 87.29%
ENDNOTES
THE FUND'S SHARE PRICE AND YIELD WILL 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 maximum sales
charge.
(4) Distribution rate is based on the sum of distributions per share for the
last 30 days of September and the maximum offering price of $10.16 on
9/30/05.
(5) Yield, calculated as required by the SEC, is based on the earnings of the
Fund's portfolio for the 30 days ended 9/30/05.
(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 approximately 179 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 3/31/05 VALUE 9/30/05 PERIOD* 3/31/05-9/30/05
- -------------------------------------------------------------------------------------------------------------
Actual $1,000 $1,018.30 $2.78
- -------------------------------------------------------------------------------------------------------------
Hypothetical (5% return before expenses) $1,000 $1,022.31 $2.79
- -------------------------------------------------------------------------------------------------------------
* Expenses are equal to the annualized expense ratio of 0.55%, multiplied by
the average account value over the period, multiplied by 183/365 to
reflect the one-half year period.
Annual Report | 11
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
FINANCIAL HIGHLIGHTS
-------------------------------------------------------------
YEAR ENDED SEPTEMBER 30,
2005 2004 2003 2002 2001
-------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net asset value, beginning of year ....................... $ 9.96 $ 10.06 $ 10.36 $ 10.27 $ 9.77
-------------------------------------------------------------
Income from investment operations:
Net investment income(a) ................................ 0.391 0.328 0.285 0.488 0.657
Net realized and unrealized gains (losses) .............. (0.123) 0.112 0.048 0.280 0.539
-------------------------------------------------------------
Total from investment operations ......................... 0.268 0.440 0.333 0.768 1.196
-------------------------------------------------------------
Less distributions from:
Net investment income ................................... (0.498) (0.540) (0.542) (0.596) (0.693)
Net realized gains ...................................... -- -- (0.091) (0.082) --
-------------------------------------------------------------
Total distributions ...................................... (0.498) (0.540) (0.633) (0.678) (0.693)
-------------------------------------------------------------
Redemption fees .......................................... --(d) --(d) -- -- --
-------------------------------------------------------------
Net asset value, end of year ............................. $ 9.73 $ 9.96 $ 10.06 $ 10.36 $ 10.27
=============================================================
Total return(b) .......................................... 2.74% 4.41% 3.40% 7.79% 12.60%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of year (000's) .......................... $367,759 $376,848 $421,827 $407,701 $188,330
Ratios to average net assets:
Expenses ................................................ 0.55% 0.54% 0.52% 0.54% 0.64%
Expenses net of waiver and payments by affiliate ........ 0.55% 0.54% 0.52% 0.25% --%
Net investment income ................................... 3.97% 3.29% 2.79% 4.78% 5.98%
Portfolio turnover rate .................................. 160.36% 245.18% 288.41% 219.99% 310.95%
Portfolio turnover rate excluding mortgage dollar rolls(c) 36.26% 50.14% 125.17% 87.47% 87.91%
(a) Based on average daily shares outstanding for years ended September 30,
2001, through September 30, 2004.
(b) Total return does not reflect sales commissions or the contingent deferred
sales charges.
(c) See Note 1(d) regarding mortgage dollar rolls.
(d) Amount is less than $0.001 per share.
12 | See notes to financial statements. | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2005
- ----------------------------------------------------------------------------------------------------
PRINCIPAL AMOUNT VALUE
- ----------------------------------------------------------------------------------------------------
LONG TERM INVESTMENTS 109.2%
MORTGAGE BACKED SECURITIES 89.3%
(a)FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) ADJUSTABLE RATE 4.0%
FHLMC, 4.75%, 4/01/17 .......................................... $ 104,285 $ 105,130
FHLMC, 4.80%, 11/01/16 ......................................... 650,504 656,756
FHLMC, 4.856%, 4/01/24 ......................................... 488,245 492,380
FHLMC, 4.908%, 5/01/20 ......................................... 387,338 392,914
FHLMC, 4.954%, 5/01/30 ......................................... 609,192 627,548
FHLMC, 4.98%, 7/01/22 .......................................... 2,302,988 2,342,687
FHLMC, 4.985%, 11/01/25 ........................................ 143,267 146,020
FHLMC, 5.011%, 7/01/24 ......................................... 415,998 426,114
FHLMC, 5.049%, 9/01/27 ......................................... 341,068 350,434
FHLMC, 5.114%, 11/01/25 ........................................ 793,619 813,262
FHLMC, 5.134%, 5/01/22 ......................................... 329,256 336,683
FHLMC, 5.158%, 12/01/30 ........................................ 306,592 315,583
FHLMC, 5.215%, 1/01/32 ......................................... 493,092 503,805
FHLMC, 5.25%, 4/01/18 .......................................... 160,525 164,326
FHLMC, 5.335%, 10/01/18 ........................................ 329,323 334,181
FHLMC, 5.356%, 3/01/19 ......................................... 366,897 374,045
FHLMC, 5.878%, 1/01/28 ......................................... 524,043 534,131
FHLMC, 5.901%, 1/01/31 ......................................... 643,732 658,122
FHLMC, 5.968%, 7/01/30 ......................................... 761,131 776,243
FHLMC, 6.004%, 5/01/32 ......................................... 173,568 175,878
FHLMC, 6.165%, 8/01/31 ......................................... 149,150 150,049
FHLMC, 6.335%, 4/01/30 ......................................... 3,336,824 3,438,550
FHLMC, 6.689%, 4/01/31 ......................................... 71,862 73,931
FHLMC, 6.871%, 11/01/19 ........................................ 295,189 307,293
------------
14,496,065
------------
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) FIXED RATE 31.7%
FHLMC Gold 15 Year, 4.50%, 10/01/18 ............................ 10,488,058 10,291,606
FHLMC Gold 15 Year, 4.50%, 11/01/18 ............................ 4,909,760 4,817,795
FHLMC Gold 15 Year, 4.50%, 11/01/18 - 3/01/20 .................. 7,799,139 7,646,530
FHLMC Gold 15 Year, 5.00%, 10/01/17 - 8/01/18 .................. 5,437,810 5,429,778
FHLMC Gold 15 Year, 5.50%, 10/01/18 - 4/01/19 .................. 3,147,461 3,195,301
FHLMC Gold 15 Year, 6.50%, 3/01/09 - 4/01/11 ................... 8,004 8,268
FHLMC Gold 15 Year, 7.00%, 6/01/09 - 7/01/11 ................... 9,430 9,838
FHLMC Gold 15 Year, 7.50%, 4/01/10 ............................. 3,880 4,098
FHLMC Gold 15 Year, 8.00%, 1/01/10 - 12/01/12 .................. 192,867 203,644
FHLMC Gold 20 Year, 6.50%, 2/01/19 ............................. 956,029 992,181
(b)FHLMC Gold 30 Year, 5.00%, 10/01/33 ............................ 12,188,000 11,929,005
FHLMC Gold 30 Year, 5.00%, 10/01/33 - 7/01/35 .................. 6,380,516 6,250,327
FHLMC Gold 30 Year, 5.00%, 7/01/35 ............................. 8,911,001 8,726,097
FHLMC Gold 30 Year, 5.50%, 9/01/33 ............................. 727,664 728,651
(b)FHLMC Gold 30 Year, 5.50%, 10/01/33 ............................ 17,000,000 17,005,304
FHLMC Gold 30 Year, 5.50%, 1/01/35 ............................. 15,935,754 15,950,068
FHLMC Gold 30 Year, 6.00%, 7/01/28 - 6/01/34 ................... 910,872 927,022
FHLMC Gold 30 Year, 6.00%, 8/01/34 ............................. 5,833,734 5,938,052
FHLMC Gold 30 Year, 6.50%, 11/01/27 - 7/01/32 .................. 1,757,406 1,814,407
Annual Report | 13
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2005 (CONTINUED)
- ---------------------------------------------------------------------------------------------------------
PRINCIPAL AMOUNT VALUE
- ---------------------------------------------------------------------------------------------------------
LONG TERM INVESTMENTS (CONT.)
MORTGAGE BACKED SECURITIES (CONT.)
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) FIXED RATE (CONT.)
FHLMC Gold 30 Year, 7.00%, 9/01/21 - 7/01/32 .................... $ 5,962,267 $ 6,239,174
FHLMC Gold 30 Year, 7.50%, 10/01/25 - 8/01/32 ................... 1,797,516 1,906,289
FHLMC Gold 30 Year, 8.00%, 7/01/24 - 5/01/30 .................... 272,464 291,357
FHLMC Gold 30 Year, 8.50%, 10/01/17 - 9/01/30 ................... 705,907 758,243
FHLMC Gold 30 Year, 9.00%, 9/01/30 .............................. 678,631 750,561
FHLMC Gold 30 Year, 9.25%, 12/01/08 ............................. 81,837 83,716
FHLMC Gold 30 Year, 9.50%, 12/01/16 - 4/01/25 ................... 2,011,157 2,214,066
FHLMC Gold 30 Year, 10.00%, 1/01/19 ............................. 235,439 264,293
FHLMC PC 20 Year, 8.50%, 5/01/17 ................................ 1,650,133 1,779,819
FHLMC PC 25 Year, 9.25%, 8/01/14 ................................ 7,841 8,501
FHLMC PC 25 Year, 9.50%, 12/01/09 ............................... 83,576 88,049
FHLMC PC 30 Year, 8.00%, 4/01/08 ................................ 5,007 5,186
FHLMC PC 30 Year, 8.50%, 2/01/17 ................................ 16,400 17,763
FHLMC PC 30 Year, 9.00%, 7/01/08 - 6/01/16 ...................... 6,551 6,950
FHLMC PC 30 Year, 9.125%, 9/01/17 ............................... 4,713 5,108
FHLMC PC 30 Year, 9.25%, 3/01/10 ................................ 930 949
FHLMC PC 30 Year, 9.50%, 8/01/19 ................................ 208,207 225,605
-------------
116,513,601
-------------
(a)FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) ADJUSTABLE RATE 9.1%
FNMA, 3.872%, 1/01/18 ........................................... 3,213,506 3,231,084
FNMA, 4.125%, 9/01/18 ........................................... 60,416 61,018
FNMA, 4.229%, 9/01/33 ........................................... 3,193,481 3,061,688
FNMA, 4.344%, 5/01/27 ........................................... 476,719 493,061
FNMA, 4.347%, 1/01/35 ........................................... 1,333,112 1,330,561
FNMA, 4.43%, 7/01/17 ............................................ 274,041 275,104
FNMA, 4.648%, 10/01/19 .......................................... 595,160 593,938
FNMA, 4.659%, 10/01/24 .......................................... 737,998 763,414
FNMA, 4.662%, 8/01/27 ........................................... 174,923 179,983
FNMA, 4.664%, 6/01/25 ........................................... 282,344 288,602
FNMA, 4.725%, 5/01/27 ........................................... 1,427,727 1,459,574
FNMA, 4.726%, 10/01/32 .......................................... 4,914,473 4,941,211
FNMA, 4.729%, 12/01/22 .......................................... 359,744 367,298
FNMA, 4.758%, 7/01/25 ........................................... 212,387 218,289
FNMA, 4.767%, 11/01/34 .......................................... 425,853 428,817
FNMA, 4.797%, 7/01/19 ........................................... 2,740,497 2,798,285
FNMA, 4.816%, 7/01/14 ........................................... 597,849 606,966
FNMA, 4.899%, 4/01/21 ........................................... 120,033 122,124
FNMA, 4.925%, 4/01/27 ........................................... 376,916 387,246
FNMA, 4.943%, 8/01/26 ........................................... 391,152 397,884
FNMA, 5.043%, 4/01/18 ........................................... 70,125 72,482
FNMA, 5.091%, 12/01/31 .......................................... 327,508 334,335
FNMA, 5.10%, 6/01/17 ............................................ 214,801 217,905
FNMA, 5.126%, 11/01/31 .......................................... 1,552,093 1,591,734
FNMA, 5.143%, 10/01/29 .......................................... 605,305 622,294
FNMA, 5.149%, 5/01/25 ........................................... 46,263 47,619
FNMA, 5.16%, 1/01/17 ............................................ 928,931 935,412
14 | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2005 (CONTINUED)
- ------------------------------------------------------------------------------------------------------------
PRINCIPAL AMOUNT VALUE
- ------------------------------------------------------------------------------------------------------------
LONG TERM INVESTMENTS (CONT.)
MORTGAGE BACKED SECURITIES (CONT.)
(a)FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) ADJUSTABLE RATE (CONT.)
FNMA, 5.175%, 10/01/29 ............................................... $ 33,540 $ 34,708
FNMA, 5.235%, 2/01/32 ................................................ 338,966 345,817
FNMA, 5.264%, 5/01/28 ................................................ 924,876 940,713
FNMA, 5.27%, 7/01/27 ................................................. 316,408 323,325
FNMA, 5.333%, 8/01/29 ................................................ 246,455 253,298
FNMA, 5.345%, 8/01/29 ................................................ 92,783 92,666
FNMA, 5.44%, 5/01/21 ................................................. 527,245 536,956
FNMA, 5.482%, 11/01/28 ............................................... 168,295 172,403
FNMA, 5.523%, 1/01/32 ................................................ 369,172 378,912
FNMA, 5.566%, 8/01/30 ................................................ 208,619 214,134
FNMA, 5.642%, 8/01/32 ................................................ 155,338 159,953
FNMA, 5.691%, 5/01/30 ................................................ 203,692 208,022
FNMA, 5.722%, 10/01/32 ............................................... 394,065 414,419
FNMA, 5.785%, 7/01/31 ................................................ 1,640,902 1,684,860
FNMA, 5.846%, 5/01/31 ................................................ 57,160 59,791
FNMA, 5.95%, 4/01/18 ................................................. 228,295 236,029
FNMA, 5.955%, 7/01/26 ................................................ 99,369 100,972
FNMA, 6.017%, 6/01/31 ................................................ 656,646 667,884
FNMA, 6.033%, 7/01/31 ................................................ 153,979 158,391
FNMA, 6.163%, 12/01/24 ............................................... 164,833 168,077
FNMA, 6.299%, 4/01/31 ................................................ 145,714 148,701
FNMA, 7.279%, 9/01/32 ................................................ 460,994 479,159
------------
33,607,118
------------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) FIXED RATE 29.3%
FNMA 15 Year, 5.00%, 6/01/18 - 4/01/20 ............................... 7,142,365 7,128,822
FNMA 15 Year, 5.00%, 7/01/18 ......................................... 6,331,723 6,323,986
FNMA 15 Year, 5.50%, 5/01/14 - 2/01/18 ............................... 6,078,601 6,172,790
FNMA 15 Year, 6.00%, 1/01/11 - 5/01/17 ............................... 5,820,052 5,989,657
FNMA 15 Year, 6.50%, 9/01/08 - 10/01/16 .............................. 597,220 617,948
FNMA 15 Year, 7.00%, 11/01/11 ........................................ 1,929 2,016
FNMA 15 Year, 7.50%, 7/01/09 - 7/01/12 ............................... 50,582 53,506
FNMA 20 Year, 6.50%, 5/01/16 - 5/01/19 ............................... 5,673,032 5,895,418
FNMA 30 Year, 5.00%, 4/01/34 ......................................... 1,742,148 1,708,395
(b)FNMA 30 Year, 5.00%, 10/01/33 ........................................ 15,000,000 14,685,930
FNMA 30 Year, 5.50%, 9/01/33 - 12/01/34 .............................. 12,926,228 12,935,393
FNMA 30 Year, 5.50%, 11/01/34 ........................................ 22,731,761 22,740,512
FNMA 30 Year, 6.00%, 12/01/23 - 11/01/34 ............................. 3,275,733 3,332,238
FNMA 30 Year, 6.50%, 12/01/27 - 8/01/32 .............................. 11,148,319 11,497,349
FNMA 30 Year, 7.00%, 6/01/24 - 10/01/32 .............................. 2,678,493 2,804,971
FNMA 30 Year, 7.50%, 8/01/25 - 5/01/32 ............................... 715,807 758,143
FNMA 30 Year, 8.00%, 1/01/25 - 7/01/31 ............................... 144,020 154,044
FNMA 30 Year, 8.50%, 11/01/26 - 11/01/28 ............................. 2,059,646 2,245,576
FNMA 30 Year, 9.00%, 8/01/09 - 9/01/26 ............................... 562,496 597,920
FNMA 30 Year, 9.25%, 10/01/09 ........................................ 11,386 11,635
FNMA 30 Year, 9.50%, 11/01/15 - 4/01/30 .............................. 885,921 972,458
FNMA 30 Year, 10.00%, 7/01/16 - 4/01/21 .............................. 674,468 749,891
Annual Report | 15
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2005 (CONTINUED)
- -----------------------------------------------------------------------------------------------------------------
PRINCIPAL AMOUNT VALUE
- -----------------------------------------------------------------------------------------------------------------
LONG TERM INVESTMENTS (CONT.)
MORTGAGE BACKED SECURITIES (CONT.)
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) FIXED RATE (CONT.)
FNMA 30 Year, 10.50%, 1/01/16 - 5/01/30 ................................ $ 68,414 $ 75,609
FNMA 30 Year, 11.00%, 10/01/15 - 6/01/30 ............................... 84,340 94,098
FNMA 30 Year, 12.00%, 4/01/15 - 5/01/16 ................................ 5,717 6,365
FNMA 30 Year, 12.50%, 12/01/13 ......................................... 1,516 1,694
FNMA GL 20 Year, 10.00%, 8/01/15 ....................................... 62,755 69,859
FNMA GL 30 Year, 8.00%, 6/01/26 ........................................ 375 402
FNMA GL 30 Year, 9.00%, 11/01/11 ....................................... 232,958 248,511
FNMA PL 30 Year, 10.00%, 9/01/20 ....................................... 25,644 28,668
-------------
107,903,804
-------------
(a)GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) ADJUSTABLE RATE 0.2%
GNMA, 4.125%, 11/20/25 ................................................. 157,884 160,575
GNMA, 4.75%, 7/20/27 ................................................... 487,754 494,460
-------------
655,035
-------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) FIXED RATE 15.0%
GNMA I SF 15 Year, 7.00%, 4/15/14 ...................................... 83,392 87,599
GNMA I SF 15 Year, 8.00%, 9/15/15 ...................................... 116,822 125,255
GNMA I SF 30 Year, 5.00%, 4/15/34 - 7/15/34 ............................ 8,274,604 8,196,198
GNMA I SF 30 Year, 5.50%, 9/15/33 - 6/15/34 ............................ 2,517,404 2,543,252
GNMA I SF 30 Year, 6.00%, 2/15/29 - 12/15/33 ........................... 2,221,501 2,276,637
GNMA I SF 30 Year, 6.50%, 1/15/24 - 9/15/32 ............................ 1,105,142 1,151,077
GNMA I SF 30 Year, 7.00%, 10/15/09 - 2/15/32 ........................... 1,944,756 2,030,315
GNMA I SF 30 Year, 7.50%, 10/15/23 - 10/15/29 .......................... 208,277 221,757
GNMA I SF 30 Year, 8.00%, 1/15/17 - 1/15/28 ............................ 681,568 730,151
GNMA I SF 30 Year, 8.25%, 4/15/06 - 5/15/21 ............................ 404,136 433,688
GNMA I SF 30 Year, 8.50%, 6/15/16 - 7/15/24 ............................ 629,924 688,689
GNMA I SF 30 Year, 9.00%, 8/15/08 - 8/15/28 ............................ 236,110 252,103
GNMA I SF 30 Year, 9.50%, 10/15/09 - 10/15/20 .......................... 165,604 177,192
GNMA I SF 30 Year, 10.00%, 10/15/18 - 2/15/19 .......................... 10,826 12,153
GNMA I SF 30 Year, 10.50%, 1/15/16 ..................................... 1,226 1,379
GNMA II SF 15 Year, 9.00%, 8/20/06 ..................................... 204 204
GNMA II SF 30 Year, 5.00%, 9/20/33 ..................................... 10,986,248 10,858,148
GNMA II SF 30 Year, 5.00%, 1/20/34 ..................................... 7,952,103 7,851,941
GNMA II SF 30 Year, 6.00%, 3/20/34 ..................................... 4,380,162 4,468,731
GNMA II SF 30 Year, 6.00%, 4/20/34 - 6/20/34 ........................... 4,562,451 4,657,925
GNMA II SF 30 Year, 6.50%, 1/20/26 - 2/20/34 ........................... 2,051,011 2,125,367
GNMA II SF 30 Year, 7.00%, 3/20/27 - 11/20/32 .......................... 3,297,242 3,452,609
GNMA II SF 30 Year, 7.50%, 11/20/22 - 7/20/32 .......................... 2,146,359 2,272,098
GNMA II SF 30 Year, 8.00%, 1/20/17 - 8/20/26 ........................... 277,570 295,897
GNMA II SF 30 Year, 8.50%, 7/20/16 - 8/20/16 ........................... 92,251 99,831
GNMA II SF 30 Year, 9.00%, 11/20/19 - 3/20/25 .......................... 16,260 17,810
GNMA II SF 30 Year, 10.50%, 6/20/20 .................................... 29 33
-------------
55,028,039
-------------
TOTAL MORTGAGE-BACKED SECURITIES (COST $330,590,717) ................... 328,203,662
-------------
16 | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2005 (CONTINUED)
- -------------------------------------------------------------------------------------------------------------------
PRINCIPAL AMOUNT VALUE
- -------------------------------------------------------------------------------------------------------------------
LONG TERM INVESTMENTS (CONT.)
ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES 19.9%
FINANCE 19.9%
(a)AFC Home Equity Loan Trust, 1997-4, 2A2, FRN, 4.07%, 12/22/27 ........... $1,092,946 $ 1,093,901
Ameriquest Mortgage Securities Inc., 2003-10, AF3, 3.23%, 12/25/33 ...... 1,002,765 1,000,279
Citifinancial Mortgage Securities Inc.,
2003-1, AF3, 4.001%, 1/25/33 ......................................... 391,563 390,807
(a)2003-4, AF6, FRN, 4.493%, 10/25/33 ................................... 2,250,000 2,190,579
Contimortgage Home Equity Loan Trust, 1999-3, A6, 7.68%, 12/25/29 ....... 296,804 299,438
Countrywide Asset-Backed Certificates,
2004-7, AF4, 4.774%, 8/25/32 ......................................... 2,862,000 2,853,478
2004-12, AF6, 4.634%, 3/25/35 ........................................ 2,850,000 2,780,818
2004-13, AF6, 4.581%, 4/25/35 ........................................ 750,000 724,908
2005-10, AF6, 4.915%, 2/25/36 ........................................ 3,250,000 3,173,828
2005-11, AF4, 5.21%, 9/25/35 ......................................... 5,000,000 4,875,780
Countrywide Home Loan, 2005-12, 2A5, 5.245%, 2/25/36 .................... 3,000,000 2,999,880
Equity One ABS Inc., 2004-1, AF6, 4.205%, 4/25/34 ....................... 5,000,000 4,828,341
FNMA Whole Loan, 2003-W16, AF3, 2.91%, 11/25/33 ......................... 141,170 140,843
FNMA, G93-33, K, 7.00%, 9/25/23 ......................................... 3,468,067 3,612,955
GE Capital Commercial Mortgage Corp., 2003-CI, A4, 4.819%, 1/10/38 ...... 1,262,683 1,250,664
Greenwich Capital Commercial Funding Corp., 2004-GG1, A7, 5.317%, 6/10/36 5,000,000 5,111,047
JP Morgan Chase Commercial Mortgage Securities Corp.,
(a)2004-CB9, A4, FRN, 5.381%, 6/12/41 .................................. . 3,779,632 3,914,751
2004-LN2, A2, 5.115%, 7/15/41 ........................................ 557,685 561,096
(a)Morgan Stanley Capital I, 2004-IQ7, A4, FRN, 5.565%, 6/15/38 ............ 6,000,000 6,192,088
Popular ABS Mortgage Pass-Through Trust, 2005-3, AF6, 4.759%, 7/25/35 ... 4,750,000 4,667,323
Residential Asset Mortgage Products Inc., 2003-RS11, AI4, 4.257%, 6/25/29 500,000 497,377
Residential Asset Securities Corp.,
(a)2000-KS2, AII, FRN, 4.08%, 3/25/30 ................................... 1,590,388 1,591,629
2004-KS1, AI4, 4.213%, 4/25/32 ....................................... 2,500,000 2,475,662
Residential Funding Mortgage Securities II,
2004-HI2, A4, 5.24%, 9/25/18 ......................................... 5,000,000 4,986,125
2005-HI1, A4, 4.70%, 8/25/34 ......................................... 4,000,000 3,938,024
(a)Travelers Mortgage Services Inc., 1998-5A, A, FRN, 4.57%, 12/25/18 ...... 237,405 238,312
Vanderbilt Mortgage Finance, 1998-C, 1A6, 6.75%, 10/07/28 ............... 100,000 104,296
Wells Fargo Home Equity Trust, 2004-2, AI5, 4.89%, 11/25/28 ............. 6,868,000 6,810,176
-------------
TOTAL ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES
(COST $74,201,458) ..................................................... 73,304,405
-------------
TOTAL LONG TERM INVESTMENTS (COST $404,792,175) ......................... 401,508,067
-------------
SHORT TERM INVESTMENTS 2.7%
U.S. GOVERNMENT SECURITIES (COST $99,467) 0.0%(c)
(d),(e)U.S. Treasury Bill, 11/25/05 ............................................ 100,000 99,517
-------------
TOTAL INVESTMENTS BEFORE MONEY FUND (COST $404,891,642) ................. 401,607,584
-------------
Annual Report | 17
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2005 (CONTINUED)
- -----------------------------------------------------------------------------------------------------------
SHARES VALUE
- -----------------------------------------------------------------------------------------------------------
SHORT TERM INVESTMENTS (CONT.)
MONEY FUND (COST $9,918,350) 2.7%
(f)Franklin Institutional Fiduciary Trust Money Market Portfolio .. 9,918,350 $ 9,918,350
--------------
TOTAL INVESTMENTS (COST $414,809,992) 111.9% ................... 411,525,934
OTHER ASSETS, LESS LIABILITIES (11.9)% ......................... (43,767,138)
--------------
NET ASSETS 100.0% .............................................. $ 367,758,796
==============
SELECTED PORTFOLIO ABBREVIATIONS
FRN - Floating Rate Note
GL - Government Guaranteed Loan
PC - Participation Certificate
PL - Project Loan
SF - Single Family
(a) The coupon rate shown represents the rate at period end.
(b) See Note 1(b) regarding securities purchased on a to-be-announced basis.
(c) Rounds to less than 0.05% of net assets.
(d) The security is traded on a discount basis with no stated coupon rate.
(e) On deposit with broker for initial margin on futures contracts (Note
1(c)).
(f) See Note 7 regarding investments in the Franklin Institutional Fiduciary
Trust Money Market Portfolio.
18 | See notes to financial statements. | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
FINANCIAL STATEMENTS
STATEMENT OF ASSETS AND LIABILITIES
September 30, 2005
Assets:
Investments in securities:
Cost - Unaffiliated issuers ........................................ $ 404,891,642
Cost - Sweep Money Fund (Note 7) ................................... 9,918,350
--------------
Total cost of investments .......................................... $ 414,809,992
==============
Value - Unaffiliated issuers ....................................... $ 401,607,584
Value - Sweep Money Fund (Note 7) .................................. 9,918,350
--------------
Total value of investments ......................................... 411,525,934
Receivables:
Investment securities sold ......................................... 355,406
Capital shares sold ................................................ 315,303
Interest ........................................................... 1,643,786
Variation margin ................................................... 2,566
--------------
Total assets ................................................. 413,842,995
==============
Liabilities:
Payables:
Investment securities purchased .................................... 43,914,514
Capital shares redeemed ............................................ 1,697,200
Affiliates ......................................................... 137,273
Distributions to shareholders ...................................... 241,665
Accrued expenses and other liabilities .............................. 93,547
--------------
Total liabilities ............................................ 46,084,199
--------------
Net assets, at value ....................................... $ 367,758,796
==============
Net assets consist of:
Paid-in capital ..................................................... $ 384,250,325
Distributions in excess of net investment income .................... (387,249)
Net unrealized appreciation (depreciation) .......................... (3,279,058)
Accumulated net realized gain (loss) ................................ (12,825,222)
--------------
Net assets, at value ....................................... $ 367,758,796
==============
CLASS A:
Net assets, at value ................................................ $ 367,758,796
==============
Shares outstanding .................................................. 37,786,615
==============
Net asset value per share(a) ........................................ $ 9.73
==============
Maximum offering price per share (net asset value per share / 95.75%) $ 10.16
==============
(a) Redemption price is equal to net asset value less contingent deferred
sales charges, if applicable, 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, 2005
Investment income:
Dividends from Sweep Money Fund (Note 7) .......................... 250,643
Interest .......................................................... 16,915,141
-------------
Total investment income .................................... 17,165,784
-------------
Expenses:
Management fees (Note 3a) ......................................... 1,455,855
Transfer agent fees (Note 3d) ..................................... 419,778
Custodian fees (Note 4) ........................................... 8,889
Reports to shareholders ........................................... 87,809
Registration and filing fees ...................................... 45,285
Professional fees ................................................. 19,130
Trustees' fees and expenses ....................................... 26,786
Other ............................................................. 17,599
-------------
Total expenses ............................................. 2,081,131
Expense reductions (Note 4) ................................ (2,544)
-------------
Net expenses ............................................. 2,078,587
-------------
Net investment income ................................... $ 15,087,197
-------------
Realized and unrealized gains (losses):
Net realized gain (loss) from:
Investments ...................................................... 1,446,248
Financial futures contracts ...................................... 250,125
-------------
Net realized gain (loss) ................................ 1,696,373
Net change in unrealized appreciation (depreciation) on investments (6,505,039)
-------------
Net realized and unrealized gain (loss) ............................ (4,808,666)
-------------
Net increase (decrease) in net assets resulting from operations .... $ 10,278,531
=============
20 | See notes to financial statements. | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
FINANCIAL STATEMENTS (CONTINUED)
STATEMENTS OF CHANGES IN NET ASSETS
----------------------------------
YEAR ENDED SEPTEMBER 30,
2005 2004
----------------------------------
Increase (decrease) in net assets:
Operations:
Net investment income ................................................... $ 15,087,197 $ 12,971,632
Net realized gain (loss) from investments and financial futures contracts 1,696,373 3,952,678
Net change in unrealized appreciation (depreciation) on investments ..... (6,505,039) (66,011)
----------------------------------
Net increase (decrease) in net assets resulting from operations . 10,278,531 16,858,299
Distributions to shareholders from net investment income ................. (19,157,429) (21,406,995)
Capital share transactions (Note 2) ...................................... (212,871) (40,430,232)
Redemption fees .......................................................... 2,497 52
----------------------------------
Net increase (decrease) in net assets ........................... (9,089,272) (44,978,876)
Net assets:
Beginning of year ........................................................ 376,848,068 421,826,944
----------------------------------
End of year .............................................................. $ 367,758,796 $ 376,848,068
==================================
Distributions in excess of net investment income included in net assets:
End of year .............................................................. $ (387,249) $ (367,933)
==================================
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 following summarizes the Fund's significant accounting policies.
A. SECURITY VALUATION
Securities listed on a securities exchange or on the NASDAQ National Market
System are valued at the last quoted sale price or the official closing price of
the day, respectively. Over-the-counter securities and listed securities for
which there is no reported sale are valued within the range of the most recent
quoted bid and ask prices. Securities that trade in multiple markets or on
multiple exchanges are valued according to the broadest and most representative
market. Investments in open-end mutual funds are valued at the closing net asset
value.
U.S. Government securities, mortgage pass-through securities, other
mortgage-backed securities, collateralized mortgage obligations and asset-backed
securities generally trade in the over-the-counter market rather than on a
securities exchange. The Fund may utilize independent pricing services,
quotations from bond dealers, and information with respect to bond and note
transactions, to assist in determining a current market value for each security.
The Fund's pricing services may use valuation models or matrix pricing which
considers information with respect to comparable bond and note transactions,
quotations from bond dealers, or by reference to other securities that are
considered comparable in such characteristics as rating, interest rate and
maturity date, option adjusted spread models, prepayment projections, interest
rate spreads and yield curves, to determine current value.
The Fund has procedures to determine the fair value of individual securities and
other assets for which market prices are not readily available or which may not
be reliably priced. Methods for valuing these securities may include:
fundamental analysis, matrix pricing, discounts from market prices of similar
securities, or discounts applied due to the nature and duration of restrictions
on the disposition of the securities. Due to the inherent uncertainty of
valuations of such securities, the fair values may differ significantly from the
values that would have been used had a ready market for such investments
existed. Occasionally, events occur between the time at which trading in a
security is completed and the close of the NYSE that might call into question
the availability (including the reliability) of the value of a portfolio
security held by the Fund. If such an event occurs, the securities may be valued
using fair value procedures, which may include the use of independent pricing
services. All security valuation procedures are approved by the Fund's 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
22 | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
B. SECURITIES PURCHASED ON A TBA BASIS (CONTINUED)
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.
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 mortgage-backed securities 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 its obligations.
E. INCOME TAXES
No provision has been made for U.S. income taxes because the Fund's policy is to
continue to qualify as a regulated investment company under the Internal Revenue
Code and to distribute to shareholders substantially all of its taxable income
and net realized gains.
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. Dividend income is
recorded on the ex-dividend date. Dividends from net investment income are
normally declared daily and distributed monthly to shareholders. Distributions
to shareholders are determined according to income tax regulations (tax basis).
Distributable earnings determined on a tax basis may differ from earnings
recorded in accordance with generally accepted accounting principles. These
differences may be permanent or temporary. Permanent differences
Annual Report | 23
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
F. SECURITY TRANSACTIONS, INVESTMENT INCOME, EXPENSES AND DISTRIBUTIONS
(CONTINUED)
are reclassified among capital accounts to reflect their tax character. These
reclassifications have no impact on net assets or the results of operations.
Temporary differences are not reclassified, as they will reverse in subsequent
periods.
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 expenses during the reporting period. Actual results could differ from those
estimates.
H. REDEMPTION FEES
Effective June 1, 2004, redemptions and exchanges of Fund 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.
I. GUARANTEES AND INDEMNIFICATIONS
Under the Trust's organizational documents, its officers and Trustees are
indemnified by the Trust against certain liabilities 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, 2005, 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,
2005 2004
-----------------------------------------------------------------------
SHARES AMOUNT SHARES AMOUNT
-----------------------------------------------------------------------
Shares sold ................. 7,456,991 $ 73,749,930 9,677,050 $ 96,610,106
Shares issued in reinvestment
of distributions ........... 1,619,656 15,988,181 1,741,712 17,351,096
Shares redeemed ............. (9,114,072) (89,950,982) (15,506,489) (154,391,434)
-----------------------------------------------------------------------
Net increase (decrease) ..... (37,425) $ (212,871) (4,087,727) $ (40,430,232)
=======================================================================
24 | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
3. TRANSACTIONS WITH AFFILIATES
Franklin Resources, Inc. is the holding company for various subsidiaries that
together are referred to as Franklin Templeton Investments. Certain officers and
trustees of the Fund are also officers and/or directors of the following
subsidiaries:
- --------------------------------------------------------------------------------------------
SUBSIDIARY 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 NET ASSETS
- --------------------------------------------------------------------------------
0.40% First $250 million
0.38% Over $250 million, up to and including $500 million
0.36% In excess of $500 million
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 sales and redemptions of the Fund's shares for the year:
Net sales charges received(a) ............................. $88,849
Contingent deferred sales charges retained ................ $ 2,854
(a) Net of commissions paid to unaffiliated broker/dealers
D. TRANSFER AGENT FEES
The Fund paid transfer agent fees of $419,778, of which $251,553 was retained by
Investor Services.
E. OTHER AFFILIATED TRANSACTIONS
At September 30, 2005, Advisers owned 20.54% of the Fund.
Annual Report | 25
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
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, 2005, the
custodian fees were reduced as noted in the Statement of Operations.
5. INCOME TAXES
At September 30, 2005, the Fund had tax basis capital losses which may be
carried over to offset future capital gains, if any. The capital loss
carryforwards were as follows:
Capital loss carryforwards expiring in:
2012 ...................................... $ 6,223,578
2013 ...................................... 4,584,050
-----------
$10,807,628
===========
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 treatments of wash sales, mortgage dollar roll
transactions, financial futures transactions, and paydown losses.
For tax purposes, realized capital losses occurring subsequent to October 31,
may be deferred and treated as occurring on the first day of the following
fiscal year. At September 30, 2005, the Fund deferred realized capital losses of
$1,999,491.
At September 30, 2005, the cost of investments, net unrealized appreciation
(depreciation), and undistributed ordinary income for income tax purposes were
as follows:
Cost of investments ................................ $ 415,219,088
==============
Unrealized appreciation ............................ 676,699
Unrealized depreciation ............................ (4,369,853)
--------------
Net unrealized appreciation (depreciation) ......... $ (3,693,154)
==============
Distributable earnings -
undistributed ordinary income ..................... $ 250,823
==============
26 | Annual Report
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
5. INCOME TAXES (CONTINUED)
The tax character of distributions paid during the years ended September 30,
2005 and 2004, were as follows:
--------------------------
2005 2004
--------------------------
Distributions paid from - ordinary income ..... $19,157,429 $21,406,995
==========================
6. INVESTMENT TRANSACTIONS
Purchases and sales of investments (excluding short term securities) for the
year ended September 30, 2005, aggregated $662,805,554 and $682,853,241,
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, 2005, 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 ............ 10 12/01/05 $1,000,000 $5,000
9. REGULATORY MATTERS
As part of various investigations by a number of federal, state, and foreign
regulators and governmental entities, relating to certain practices in the
mutual fund industry, including late trading, market timing and marketing
support payments to securities dealers who sell fund shares, Franklin Resources,
Inc. and certain of its subsidiaries (collectively, the "Company"), entered into
settlements with certain of those regulators.
Specifically, the Company entered into settlements with the Securities and
Exchange Commission ("SEC") concerning market timing (the "August 2, 2004 SEC
Order") and marketing support payments to securities dealers who sell fund
shares (the "December 13, 2004 SEC Order") and with the California Attorney
General's Office ("CAGO") concerning marketing support payments to securities
dealers who sell fund shares (the "CAGO Settlement"). Under the terms of
Annual Report | 27
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
9. REGULATORY MATTERS (CONTINUED)
the settlements with the SEC and the CAGO, the Company retained an Independent
Distribution Consultant ("IDC") to develop a plan for distribution of the
respective settlement monies. The CAGO approved the distribution plan under the
CAGO Settlement and, in accordance with the terms and conditions of that
settlement, the monies were disbursed to the relevant funds. The Trust did not
participate in the CAGO Settlement. The SEC has not yet approved the
distribution plan pertaining to the December 13, 2004 SEC Order. When approved,
disbursements of settlement monies will be made promptly to the relevant funds,
in accordance with the terms and conditions of that order. The IDC continues to
develop the plan of distribution under the August 2, 2004 SEC Order that
resolved the SEC's market timing investigation.
In addition, the Company, as well as most of the mutual funds within Franklin
Templeton Investments and certain current or former officers, directors, and/or
employees, have been named in private lawsuits (styled as shareholder class
actions, or as derivative actions on behalf of either the named funds or
Franklin Resources, Inc.) relating to the industry practices described above.
The lawsuits were filed in different courts throughout the country. Many of
those suits are now pending in a multi-district litigation in the United States
District Court for the District of Maryland.
The Company and fund management strongly believe that the claims made in each of
the private lawsuits referenced above are without merit and intends to defend
against them vigorously. The Company cannot predict with certainty the eventual
outcome of these lawsuits, nor whether they will have a material negative impact
on the Company. If it is determined that the Company bears responsibility for
any unlawful or inappropriate conduct that caused losses to the Trust, it is
committed to making the Trust or its shareholders whole, as appropriate.
28 | Annual Report
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, 2005, 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, 2005 by correspondence with the
custodian and brokers, provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
San Francisco, California
November 10, 2005
Annual Report | 29
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
BOARD MEMBERS AND OFFICERS
The name, year of birth 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
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------------------------------------------------------------------------------------------------------------------------
HARRIS J. ASHTON (1932) Trustee Since 1992 141 Director, Bar-S Foods (meat packing
One Franklin Parkway 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 (1932) Trustee Since 1992 142 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 (until 2002) (Consultant (2003)).
- ------------------------------------------------------------------------------------------------------------------------------------
Edith E. Holiday (1952) Trustee Since 2003 137 Director, Amerada Hess Corporation
One Franklin Parkway (exploration and refining of oil and
San Mateo, CA 94403-1906 gas), H.J. Heinz Company (processed
foods and allied products), RTI
International Metals, Inc.
(manufacture and distribution of
titanium), Canadian National Railway
(railroad), and White Mountains
Insurance Group, Ltd. (holding
company).
- ------------------------------------------------------------------------------------------------------------------------------------
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 (1929) Trustee Since 1992 115 Director, The California Center for
One Franklin Parkway Land Recycling (redevelopment).
San Mateo, CA 94403-1906
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
General Partner, Las Olas L.P. (Asset Management); and FORMERLY, Chairman, Peregrine Venture Management Company (venture capital).
- ------------------------------------------------------------------------------------------------------------------------------------
30 | Annual Report
- ------------------------------------------------------------------------------------------------------------------------------------
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------------------------------------------------------------------------------------------------------------------------
GORDON S. MACKLIN (1928) Trustee Since 1998 141 Director, Martek Biosciences
One Franklin Parkway Corporation, MedImmune, Inc.
San Mateo, CA 94403-1906 (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), White Mountains
Insurance Group, Ltd. (holding com-
pany) (1987-2004) and Spacehab,
Inc. (aerospace services) (1994-2003).
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director of various companies; and FORMERLY, Deputy Chairman, White Mountains Insurance Group, Ltd. (holding company) (2001-2004);
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
- ------------------------------------------------------------------------------------------------------------------------------------
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------------------------------------------------------------------------------------------------------------------------
**CHARLES B. JOHNSON (1933) Trustee and Trustee since 141 None
One Franklin Parkway Chairman of 1992 and
San Mateo, CA 94403-1906 the Board Chairman of the
Board since 1993
- ------------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
- ------------------------------------------------------------------------------------------------------------------------------------
Chairman of the Board, 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 43 of the investment companies in Franklin Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------
**RUPERT H. JOHNSON, JR. (1940) Trustee, Trustee since 125 None
One Franklin Parkway President and 1992, President
San Mateo, CA 94403-1906 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.; 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 46 of
the investment companies in Franklin Templeton Investments.
- ------------------------------------------------------------------------------------------------------------------------------------
Annual Report | 31
- -----------------------------------------------------------------------------------------------------------------------------------
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- -----------------------------------------------------------------------------------------------------------------------------------
**HARMON E. BURNS (1945) Vice Since 1992 Not Applicable Not Applicable
One Franklin Parkway President
San Mateo, CA 94403-1906
- -----------------------------------------------------------------------------------------------------------------------------------
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.; 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.
- -----------------------------------------------------------------------------------------------------------------------------------
JAMES M. DAVIS (1952) Chief Since 2004 Not Applicable Not Applicable
One Franklin Parkway Compliance
San Mateo, CA 94403-1906 Officer
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director, Global Compliance, Franklin Resources, Inc.; officer of 48 of the investment companies in Franklin Templeton Investments;
and FORMERLY, Director of Compliance, Franklin Resources, Inc. (1994-2001).
- -----------------------------------------------------------------------------------------------------------------------------------
LAURA FERGERSON (1962) Treasurer Since 2004 Not Applicable Not Applicable
One Franklin Parkway
San Mateo, CA 94403-1906
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice President, Franklin Templeton Services, LLC; officer of 32 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).
- -----------------------------------------------------------------------------------------------------------------------------------
JIMMY D. GAMBILL (1947) Senior Vice Since 2002 Not Applicable Not Applicable
500 East Broward Blvd. President and
Suite 2100 Chief
Fort Lauderdale, FL 33394-3091 Executive
Officer -
Finance and
Administration
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
President, Franklin Templeton Services, LLC; Senior Vice President, Templeton Worldwide, Inc.; and officer of 48 of the investment
companies in Franklin Templeton Investments.
- -----------------------------------------------------------------------------------------------------------------------------------
DAVID P. GOSS (1947) Vice Since 2000 Not Applicable Not Applicable
One Franklin Parkway President
San Mateo, CA 94403-1906
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Associate General Counsel, Franklin Resources, Inc.; officer and director of one of the subsidiaries of Franklin Resources,
Inc.; officer of 48 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).
- -----------------------------------------------------------------------------------------------------------------------------------
32 | Annual Report
- -----------------------------------------------------------------------------------------------------------------------------------
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- -----------------------------------------------------------------------------------------------------------------------------------
BARBARA J. GREEN (1947) Vice President Since 2000 Not Applicable Not Applicable
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, LLC,
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 48 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 (1937) Vice President Since 2002 Not Applicable Not Applicable
600 Fifth Avenue -AML
Rockefeller Center Compliance
New York, NY 10020-2302
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice Chairman, Chief Banking Officer and Director, Fiduciary Trust Company International; Director, Franklin Templeton
Institutional Suisse SA, Arch Chemicals, Inc. and Lingnan Foundation; and officer and/or director, 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.
- -----------------------------------------------------------------------------------------------------------------------------------
MURRAY L. SIMPSON (1937) Vice President Since 2000 Not Applicable Not Applicable
One Franklin Parkway and Secretary
San Mateo, CA 94403-1906
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Executive Vice President, Franklin Resources, Inc.; officer and/or director, as the case may be, of some of the subsidiaries of
Franklin Resources, Inc. and of 48 of the investment companies in Franklin Templeton Investments; and FORMERLY, General Counsel,
Franklin Resources, Inc.; Chief Executive Officer and Managing Director, Templeton Franklin Investment Services (Asia) Limited
(until 2000); and Director, Templeton Asset Management Ltd. (until 1999).
- -----------------------------------------------------------------------------------------------------------------------------------
Annual Report | 33
- -----------------------------------------------------------------------------------------------------------------------------------
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- -----------------------------------------------------------------------------------------------------------------------------------
GALEN G. VETTER (1951) Chief Since 2004 Not Applicable Not Applicable
500 East Broward Blvd. Financial
Suite 2100 Officer and
Fort Lauderdale, FL 33394-3091 Chief
Accounting
Officer
- -----------------------------------------------------------------------------------------------------------------------------------
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Vice President, Franklin Templeton Services, LLC; officer of 48 of the investment companies in Franklin Templeton
Investments; and FORMERLY, Managing Director, RSM McGladrey, Inc. (1999-2004); and Partner, McGladrey & Pullen, LLP (1979-1987 and
1991-2004).
- -----------------------------------------------------------------------------------------------------------------------------------
** 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.
34 | Annual Report
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 U.S. Securities and Exchange
Commission's website at sec.gov and reflect the most recent 12-month period
ended June 30.
QUARTERLY STATEMENT OF INVESTMENTS
The Fund files a complete statement of investments with the U.S. 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.
Annual Report | 35
This page intentionally left blank.
LITERATURE REQUEST
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 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-Mid Cap Growth Fund
Franklin Small Cap Growth Fund II(1)
VALUE
Franklin Balance Sheet Investment Fund(2)
Franklin Equity Income Fund
Franklin Large Cap Value Fund
Franklin MicroCap Value Fund(2)
Franklin MidCap Value Fund
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
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(4)
Franklin's AGE High Income Fund
Franklin Floating Rate Daily Access Fund
Franklin Income Fund
Franklin Limited Maturity
U.S. Government Securities Fund(4)
Franklin Low Duration Total Return Fund
Franklin Real Return Fund
Franklin Strategic Income Fund
Franklin Strategic Mortgage Portfolio
Franklin Templeton Hard Currency Fund
Franklin Total Return Fund
Franklin U.S. Government Securities Fund(4)
Templeton Global Bond Fund
Templeton Income Fund
TAX-FREE INCOME(5)
NATIONAL FUNDS
Double Tax-Free Income Fund
Federal Tax-Free Income Fund
High Yield Tax-Free Income Fund
Insured Tax-Free Income Fund(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 Michigan(6)
Arizona Minnesota(6)
California(7) Missouri
Colorado New Jersey
Connecticut New York(7)
Florida(7) North Carolina
Georgia Ohio(7)
Kentucky Oregon
Louisiana Pennsylvania
Maryland Tennessee
Massachusetts(6) Virginia
INSURANCE FUNDS
Franklin Templeton Variable Insurance Products
Trust(8)
(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) An investment in the fund is neither insured nor guaranteed by the U.S.
government or by any other entity or institution.
(5) For investors subject to the alternative minimum tax, a small portion of
fund dividends may be taxable. Distributions of capital gains are
generally taxable.
(6) Portfolio of insured municipal securities.
(7) 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).
(8) The funds of the Franklin Templeton Variable Insurance Products Trust are
generally available only through insurance company variable contracts.
09/05 Not part of the annual report
[LOGO](R)
FRANKLIN TEMPLETON One Franklin Parkway
INVESTMENTS San Mateo, CA 94403-1906
o 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 A2005 011/05
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.
(c) N/A
(d) N/A
(f) Pursuant to Item 12(a)(1), 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 $16,453 for the fiscal year ended September 30, 2005 and $19,056 for the
fiscal year ended September 30, 2004.
(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 their financial statements
were $0 for the fiscal year ended September 30, 2005 and $48,579 for the fiscal
year ended September 30, 2004. 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.
The aggregate 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 were $19,591 for the fiscal year ended
September 30, 2005 and $0 for the fiscal year ended September 30, 2004. The
services for which these fees were paid included tax compliance and advice.
(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 $0 for the fiscal year ended September 30,
2005 and $320 for the fiscal year ended September 30, 2004. 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 $4,500 for the fiscal year ended September
30, 2005 and $159,680 for the fiscal year ended September 30, 2004. 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
the review of the 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 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 $24,091 for the fiscal year ended September 30, 2005 and
$208,579 for the fiscal year ended September 30, 2004.
(h) The registrant's audit committee of the board of trustees has considered
whether the provision of non-audit services that were rendered to the
registrant's investment adviser (not including any sub-adviser whose role is
primarily portfolio management and is subcontracted with or overseen by another
investment adviser), and any entity controlling, controlled by, or under common
control with the investment adviser that provides ongoing services to the
registrant that were not pre-approved pursuant to paragraph (c)(7)(ii) of Rule
2-01 of Regulation S-X is compatible with maintaining the principal accountant's
independence.
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. PORTFOLIO MANAGERS OF CLOSED-END MANAGEMENT INVESTMENT
COMPANIES. N/A
ITEM 9. PURCHASES OF EQUITY SECURITIES BY CLOSED-END MANAGEMENT
INVESTMENT COMPANY AND AFFILIATED PURCHASERS. N/A
ITEM 10. 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 11. 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 12. EXHIBITS.
(a) (1) Code of Ethics
(a) (2) 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) 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 PORTFOLIO
By /s/JIMMY D. GAMBILL
-------------------
Jimmy D. Gambill
Chief Executive Officer - Finance and Administration
Date November 21, 2005
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
-------------------
Jimmy D. Gambill
Chief Executive Officer - Finance and Administration
Date November 21, 2005
By /s/GALEN G. VETTER
------------------
Galen G. Vetter
Chief Financial Officer
Date November 21, 2005