You can learn more about this in these posts:
Podcast: The jargon buster episode
Podcast: The Zack One Lap Index
ETF: How index trackers can ruin the market
Index-tracking investment
The basic premise of index investing – or an index-tracking investment – is simple: buy all the companies listed on a particular exchange, weighted by the size of the company. When a company does well, it grows in size, thereby improving the performance of the whole index. When a company does poorly, it no longer meets the requirements of index inclusion. Its gradual shrinking has a negative impact on the overall performance of the index for a while, but at some point the company becomes too small to be included in the index. When that happens it gets booted out and another, growing company takes its place. The growth of the small company contributes to growth of the index and all is well again.