We are interested in pursuing diversification to the point of making our portfolio free, to the greatest possible extent, of avoidable risks such as one individual company or sector going down. One criteria for obtaining such diversification, in what regards to U.S. large-capitalization companies (these are, big companies or, as investors say, large-caps) is using the same proportion as recognized stock-market indexes such as the Dow Jones Industrial Average (DJIA) or the Standard and Poor's 500 (S&P500). An important advantage of these passively-managed funds is the fact that their commisions are generally very low, because their managers are free from the task of studying and selecting company stock.
What Stock-Market Indexes Are
Stock-market indexes are measures that represent the whole of the stock market, or a particular segment of it. For example, in the widely-known cases of the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500, the segment is the universe of large-capitalization companies in the US. They are aggregate values resultant from the combination of many stock, each one in a proportion defined by their market value or by other criteria, depending on the design of the index. In other words, each index "contains" a certain percentage (usually, a small one) of shares from company A, a certain percentage from company B, etc. By adding up the current value of all that stock, we obtain the current value of the index.
The original intent of stock-market indexes was to provide a means for quantifying ups and downs of the segment they represent. For example, if the DJIA goes up a 0.8%, one may as well say that large-cap, US companies went up a 0.8%. Thus, when the index was defined, they cared to use an assignment that takes all of that stock into account, in proper proportions. This work can also be utilized for the composition of diversified funds. Actually, although the DJIA is the most-widely known index, it is not used for the composition of funds, because it includes only 30 companies. The S&P500, which lists 500, provides better diversification and has more acceptance among the experts.
There are other indexes for other universes of stock, some are more accepted than others. For example, there is the Russell 2000 for small-cap U.S. companies, Wilshire 5000 for the whole of the US market, the NASDAQ-100 for companies listed in the NASDAQ stock exchange (many are related to technology), the FTSE 100 (Footsie) for British large-caps, NIKKEI for Japanese and lots more.
Funds that follow an index are called, not surprisingly, index funds. Many mutual-funds and ETFs are index funds. The term index fund is sometimes applied to all passively-managed funds (these are funds where purchasing decisions are not decided by a manager but follow a predefined formula, such as following an index). When the passively-managed fund follows a previously-established index, the reason for using the same term is pretty clear. But when it doesn't, it also makes some sense, because it could be argued that the formula created for deciding the funds' composition is actually the definition of a new, ad-hoc index.
The underlying assets of index funds are traded infrequently, only at index updates, which occur to adapt to the evolution of companies, as some grow more than others. This results in lower fees and greater tax efficiency, as we shall later explain. Thus, index funds are great instruments for the diversified buy&hold investor.