It’s not clear why I would use this, how is virtualization supposed to work with and without this flag?

Without this flag enabled FMOD will continue to decode wave data and mix sounds which are silent. With this flag it will force silent sounds into the virtual state which means they wont decode or mix. This flag only takes effect when the number of audible sounds is less than the number of real channels. For example, if you have 16 real channels available and 100 sounds playing, then the loudest 16 will be real and the rest will be virtual. In this scenario if there are at least 16 non-silent sounds then this flag will have no effect. It is only relevant when there are fewer audible sounds than available real channels, it wont improve performance when lots of sounds are playing.

The number of real channels is dependent on System::setSoftwareChannels, and the number of codecs specified using FMOD_ADVANCEDSETTINGS.