Does sanity even have a place in heroic fantasy?
Sure it does. The Eternal Champion and Conan sagas have more than their fair share of the insane, deranged and psychotically unstable.
Even in Lord of the Rings, Denethor is barking mad, driven to this stage by disappointment, the weight of responsibility and the proximity of a strengthening Mordor. Gollum is bonkers because the ring has made him that way. Even Bilbo and Frodo display a descent into madness under the ring's burden.
For a more recent example, how about 'A Song of Ice and Fire'? Plenty of mad kings, sociopaths and psychologically scarred individuals.
Think of your favourite fantasy or mythological character and think how far he or she would have got in a straight jacket.
And many favourite fantasy characters are favourites because of such psychological afflictions!
Elric is considered mad by his own people. Corum is driven to madness by the torture of the Mabden and destruction of his people. In 'Song of Ice and Fire' Tyrion becomes psychologically scarred by the treatment of his family that he is driven to extreme acts (I won't say what in case of spoiling things for those who haven't read the full saga yet).
Madness does not indicate an inability to function. It may indicate impaired judgement and/or limited social capabilities, but it does not necessarily follow that every character suffering from some form of insanity or impairment is a howling, raging maniac.
I don't agree with it in the least. Cthulhu is specifically meant to be horror and reflects this with its sanity rules, fantasy genres see the horrors as obstacles to hack, hew and burn.
Cthulhu is a very specific kind of horror. At its core its about the unfolding realisation that humanity is surrounded and outclassed by beings of incredibly alien magnitude, and that, ultimately, humanity is alone and hopeless against these beings.
This form of horror is perfectly at home in the fantasy genre. Howard, Ashton Smith, Leiber, Moorcock and others all draw upon it for their fantasies. Witness Elric's despair in 'The Dead God's Book' when he realises that the struggle between Law and Chaos is both never-ending and treats the world as its pawn, uncaring and unconcerned for its fate. Ashton Smith frequently references the Cthulhu mythos and sends his fantasy protagonists barmy as they are exposed to its horrors. He uses similar tools where magic is concerned too, particularly the hideously corrupting power of sorcery.
The average amount of gore, disemboweling and beheading in most fantasy sessions would render a Cthulhu party 80% insane and out of action and that's before you even get to the inhuman foes, magic, demons etc.
Depends on what events an individual may have experienced leading to becoming inured to such experiences. A WWI veteran serving at The Somme will have witnessed wholesale carnage and trauma on a scale that may leave him utterly inured to similar atrocities in everyday life. Same goes for fantasy settings too. A villager who has spent his life without witnessing the horror of battle will be affected by carnage whereas someone brought up with it day-in, day-out will be (relatively) inured.
However, events (like demons, magic etc) that have no fundamental and rational reference point will have an impact irrespective of the setting.
Sanity mechanics do have a place because they:
a) Help those who don't feel comfortable portraying someone suffering from insanity through pure roleplaying.
b) Provide a handy measure for scaling insanity.
c) Help apply the use of insanity consistently across the players - just as all other game mechanics tend to do.
I do agree that roleplaying insanity is the best way of portraying it, but that can sometimes be difficult and unrealistic. Sanity mechanics provide a handy short-hand and abstraction that can help overcome some of the inherent problems of acting it out in a realistic fashion.