See:
http://tomcat.apache.org/tomcat-6.0-doc/deployer-howto.html#A%20word%20on%20Contexts They go in tomcat/conf/Catalina/localhost/[context-name].xml
If you have configured your own host, replace the 'Catalina/localhost' part accordingly.
... why would anyone ever use this as opposed to putting the context.xml into META-INF under webapps?
You can still place a context.xml file in your META-INF diretory if you like. Just to be clear, the META-INF directory is under webapps/[context-name]/META-INF.
When I'm developing apps, I keep the code base outside of the tomcat hierarchy. Using context fragment files makes it easy to separate the two.
Lastly, don't try to put more than one context entry in a context fragment file. Each application should have its own file named [context-name].xml