No, #1 just does what it says, fills the frame so no black borders. VCD's have a low bitrate. So if you start out with higher quality input you will get some graininess or 'softness' and there really isn't much you can do about it.
I haven't made a VCD for awhile, when I did, I preferred the endcoder that came with TNPGEnc for MPEG-1, setting it to variable bitrate, double pass. It took a fairly long time to render but about as good as you can get for VCD's.
In version 4 of Vegas they now also support variable bitrate, click on the custom tab. And FOR SURE, be sure the quality slider is all the way to the right.