Index funds are nothing new. You could say that they are the offspring of mutual funds finally getting into their teen years, entering an age of self discovery. Like teens, they take on many forms, both good and bad, but in general they are much the same.
Very simply put, mutual funds trade in units and are valued at the close of business on each day based on the underlying value of the portfolio of assets the fund owns. They were designed to allow investors with a smaller amount of capital, to access a more diversified portfolio by pooling their capital with others in a grouping mechanism. Index funds operate the same way (ie: you are purchasing units of an underlying portfolio), however they are traded on the index (TSX/Dow.....) and thus are valued moment to moment based on the price the market is willing to pay. There is a small arbitrage opportunity or lack thereof that can occur this way, but ultimately the valuations are the same.
Index funds are growing. So much so that their influence is going to start to sway the market soon. I don't think they are impactful enough to be doing that quite yet as the retail investor market is still much larger.
There is however another important development that the famed Jack Bogle points out in this article in the WSJ. I think it's a must read.