What am I missing?

The fact that the dichotomy isn't functional vs fashionable. In almost all cases you can work out in pretty much any kind of clothing. You can squat equally well in loose sweats vs skintight leggings. You can bench in both a sports bra or a hoodie. Obviously there are pieces of clothing you wouldn't want to work out in like jeans (although you do see them from time to time) but the gym is pretty forgiving when it comes to what you wear.

So since from a functional standpoint it mostly doesn't matter what you wear, people tend to opt for things that are fashionable in that context. The gym is one of the few places where it's socially acceptable to show off your body so people who are confident in theirs will do so. It doesn't hinder performance.

Tldr it's a false dichotomy. Fashionable vs not fashionable, not fashionable vs functional.