Text looks pixelated when viewing on external display on MacBook Air M1

[!!!]

From what I understand, macOS is heavily optimized for retina displays (the one on your MacBook) that text on non macbook displays just look very bad because macOS thinks that all displays are retina displays... its so annoying but it is what it is.

Small correction here, macOS used to look fine on 1080p displays, then in Mojave Apple hide the option, and in subsequent versions Apple outright removed it. It's not a case of "just how the universe works", it's that Apple has intentionally removed code, right around the time they started rolling out their own displays. Up to you if you believe this is a malicious attempt by Apple to make other displays look worse in comparison to their extremely overpriced displays.

I aren't sure why, but using the virtual display, seems to enable the MacOS scaling options that are available for only Apple displays, which doesn't cause the pixelation.

Yes, that's the "trick" for the application, it gets macOS to unhide the normally hidden display scaling options for certain external displays.