Something has happened that John Bogle probably never would have imagined in his wildest dreams: Index investing is trendy. Old-fashioned index mutual funds like Vanguard's own 500 Index Fund (FUND:VFINX) continue to bring in new investors, while pioneer ETF SPDR Trust (AMEX:SPY) has been joined by dozens of other exchange-traded funds, many of which track a particular index. This explosion in the number of ETFs has been accompanied by a corresponding increase in the number of indices that exist. For every conceivable class and subclass of investing, it seems, you can find an index that purports to track it and that provides an index mutual fund or ETF with the opportunity to mirror it.

It's not hard to understand why. As a previous article discussed, S&P's tracking at the end of the third quarter showed that its indices were again outperforming the majority of actively managed mutual funds in 2006, with the large-cap S&P 500 index ahead of more than 70% of large-cap funds with active management for the year. Analysis over longer periods was equally grim for actively managed funds. Although there have been other periods during which active management produced better results than the indices, the simplicity and low expenses of most index funds and ETFs makes them attractive investment choices.

The good and the bad of indexing
It's important to understand that index funds are essentially slaves to the index they happen to follow. As a result, index funds don't always make great investments. For instance, the addition of JDS Uniphase (NASDAQ:JDSU) to the S&P 500 in July 2000 corresponded almost perfectly with the stock's final rise -- before it plummeted more than 98% to its present levels. In contrast, Rite Aid (NYSE:RAD), the stock JDS Uniphase replaced, has actually risen slightly since it was removed from the index. A look at the list of additions and deletions from the S&P 500 during the technology boom uncovers a host of names that the index added at or near all-time peaks, in some cases immediately before the huge drops that resulted from the burst of the tech bubble. For a recent example, one could look at the recent addition of Google (NASDAQ:GOOG) this past March, after the stock had run up from its initial trades below 100 to nearly 400; so far, the stock has climbed another 100 points, and there's great debate about whether it will eventually fall. Regardless, index funds dutifully follow the moves made by S&P and other companies that create and manage stock indices.

On the other hand, one nice thing about index funds is that you always know that you're fully invested in whatever market you select, and it's easy to tell what stocks the fund owns and in roughly what proportions it owns them. With actively managed funds, on the other hand, you can never quite be sure whether they hold a particular stock; by the time a list of holdings appears in a semi-annual report, the actual companies the fund owns may have changed dramatically. Index funds are almost perfectly transparent, keeping investors from having to suffer unwanted surprises.

Taking advantage of indexing
The mindless devotion that index funds have toward changes in their target index can create opportunities for investors. When stocks are added to or deleted from an index, the company that manages the index gives notice of the addition or deletion in advance. This gives index funds and other investors time to prepare for the change. However, it also gives traders a chance to buy stock in companies that are being added to a given index before the index funds buy shares. For example, in late November, S&P announced that DirecTV (NYSE:DTV) would be added to the S&P 500 index as of the end of trading Dec. 1. When the stock opened for trading the following day, it rose nearly 4%. In this particular case, however, these artificially high prices didn't last long, and by the end of the day, the stock had given back all but about 1% of its gains. By Dec. 1, even though DirecTV's volume of about 120 million shares was nearly 15 times its average volume, there weren't significant disruptions in the trading of the stock. Even though it isn't a sure thing that you can earn a quick profit on a short-term trade using this strategy, index changes usually raise the risk of a market disruption in the trading of stocks to be added to or deleted.

On the other hand, there may also be an opportunity to profit from stocks that get deleted from an index. If selling pressure resulting from the dropping of a stock from an index artificially lowers prices temporarily, then the stock may recover after index funds have sold out. For instance, Louisiana Pacific (NYSE:LPX) was dropped from the S&P 500 in early November after a substantial drop in share prices brought its market capitalization down to levels more reminiscent of mid-cap stocks. In the days surrounding its deletion, Louisiana Pacific hit multi-year lows, but since then, the stock has rebounded about 15%. Of course, positive fundamentals don't hurt, and one example doesn't prove a trend, but there is some logic to the strategy.

For those who are content with market-matching returns, index funds do an admirable job of earning them. Even if additions and deletions to indices create inefficiencies, the effect on index fund investors is negligible; a temporary blip in a single stock in the S&P 500 may hurt fund investors by only a few hundredths of a percentage point. However, these inefficiencies may result in much bigger gains by nimble traders who seek bargains among the stocks the index funds have to sell.

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Fool contributor Dan Caplinger has always been a big fan of index funds for their low expenses. He doesn't directly own shares of the companies mentioned in this article, although his stock index funds own a small piece of most of them. The Fool's disclosure policy keeps up with additions and deletions.