First, What's an Index?

When investors use the word "index," they're talking about a particular portfolio of investments. An index provides a way to see how broad or specific markets change without having to actually look at every stock in that market. And while indices do a good job of measuring market movement, they've also become a great way to capitalize on the upward trend of the stock market.

Indices basically work like this: the index's creator picks the stocks, bonds, or other investments that the index will track, and finds an average price for the index as a whole. There are a few different methods for finding this average price, though most indices today use weighting to determine the effect each holding will have on the index as a whole.

What's an Index Fund?

Indices aren't just used to get a feel for the markets these days; there's big money in index funds. Index funds are funds (mutual funds or ETFs) whose portfolios are kept identical to those of a specific index. The emergence and accessibility of ETFs have made the idea of investing in an index even more appealing to individual investors. The most popular ETF (by volume, according to Morningstar) is the "Spiders" (or "SPDRs") (SPY - Cramer's Take - Stockpickr), which mirrors the S&P 500 index.

Don't assume that index funds are bland investments just because the two most famous indices in the U.S. measure mainly domestic "blue chips." There's a lot of variety in index funds.

Index Fund Variety

While everyone knows the S&P 500 and the Dow, there are a lot of indices out there that can offer exposure to the markets you're after. First off, some indices represent sectors of larger indices like the S&P 500. The Technology SPDR (XLK - Cramer's Take - Stockpickr) represents just the technology sector of the S&P 500. There are also index funds that measure mid-cap and small-cap stocks, international stocks, and other types of investments like bonds and commodities.

In fact, many ETFs track indices of foreign companies. The iShares MSCI Japan Index ETF (EWJ - Cramer's Take - Stockpickr) and Brazil Index ETF (EWZ - Cramer's Take - Stockpickr) are prime examples of exceedingly popular ETFs that mirror two of Morgan Stanley's foreign indices. Index-based ETFs can be a fantastic way to break into emerging markets (see BRIC ETF Investing: An Introduction).

To learn more about ETF investing, visit TheStreet.com ETF Center .

Why an Index Fund?

So what is it that makes an index-based mutual fund or ETF more tempting than their actively managed counterparts? Simply put, they're relatively cheap. As a rule, index funds have significantly lower expenses than actively managed funds.

Even with lower fees, long term, index funds don't disappoint in their returns. However, those returns may not always be so "mirror-like."

Next: Understand the Risks of Index Funds