As soon as you start talking about folklore, you have to ask yourself whose view you’re going to use.
There are terms for this in anthropology and related fields, that I believe we stole from linguistics: emic and etic. (They’re actually lopped-off forms of “phonemic” and “phonetic,” though in the latter case it gets pronounced both “ett-ick” and “ee-tick,” depending on who’s talking.) The emic view of something is culture-specific: it’s the way a given group of people describe, explain, categorize, etc, a particular thing in their own society. The etic view is the “universal” one: it’s a standardized approach used across multiple cultures. Or, in simpler terms, emic is the insider view, and etic is the outsider one.
In folklore, one way this manifests is in the classification of narrative forms. Folklorists have taken certain Western-derived categories — e.g. myth, legend, and folktale — and tried to define them in a fashion that allows us to find similar types of stories in other parts of the world. I’ll get into each of these in more detail later on, but for now we can say that myth, to pick one example, is a sacred story that tells how things came into being. (That’s not quite the layperson usage of the term, of course, which is why I’ll be posting more about this in the future.)
That’s the etic structure. From the emic side, things might look very different. I’ve forgotten most of the actual examples from my grad school readings, but since we’re talking about folklore in the context of fantasy, I’m going to go ahead and make a few up: our hypothetical fantasy society groups its narratives into the categories of winter stories, teaching tales, women’s stories, and green speech. The first are told only during the winter season (a restriction that appears among the Navajo, as well as other real-world groups), the second are told to children and misbehaving adults, the third are told only among women, and the fourth is a class of philosophical koan-type things with religious significance.
None of these map to the etic categories of myth, folktale, and legend. Green spech is sacred, but doesn’t relate how things began; that’s mostly found among teaching tales, and a small number of winter stories and women’s stories. Folktale-type-things are common among women, but not exclusively there. Etc. The two systems cut across one another, their boundaries rarely if ever lining up.
So which one’s better? It depends on what you’re trying to do, and both are useful in their own way. Etic systems are vital for cross-cultural comparison, for understanding what happens when one narrative culture and another come into contact. Emic systems, on the other hand, tell you a lot more about how that particular group views the world.
It’s not uncommon for fantasy writers to invent folklore within the worlds they write about. But a lot of the time we fall into the trap of following the systems we know — which is, for most of us, the Western-derived triumvirate of myth, legend, and folktale, along with other things like fables or tall tales. We don’t often think to include taboos about when and where and how certain types of stories might be told, and why those taboos might exist. A fantasy society that’s nomadic, or that used to be nomadic, might require important stories to be told under the open sky. Some things might be for men only, or children only, or post-menopausal women only. Certain tales might have to be told in sets of three, never alone or in other combinations. A tropical culture might have wet-season stories, and a fear that if they get told at the wrong time of year, the rains might never come again. (And they might be right. This is fantasy: the rules are what you make them.)
I’m guilty myself of insufficient creativity on this point. When I started developing the Nine Lands (a setting I haven’t played much in lately, but hope to go back to), I spent a while trying to write three kinds of background stories for each culture: myth, folktale, and history. The exercise produced some interesting material, but I did myself a disservice by standardizing that across the entire world. Etic systems are great for comparative purposes, but what I really needed was cultural specificity. Fantasy is capable of so much more variation and creativity than it defaults to. We — and I very much include myself in this — can stretch further, and find different ways of categorizing our narrative world.