Why are they so ugly?

The problem in Sims 2 is that they actually look too much like their parents. 

Later games do a better job of combining elements from the parents and applying them in a way that works fairly seamlessly. In contrast Sims 2 is very basic in how it does it. It literally takes bits from each parent and puts them together on a toddler's frame. Which, of course, looks weird. They have to grow into the bits and tend to look normal by their teens. Even then, some combinations of bits may still look odd. One parents eyes with the other parent's nose may not quite work on their face shape. I have a mod to allow me to use the plastic surgery object starting with teens so I can fix any bits I don't like as soon as possible. The only way to guarantee you will start out with a good looking toddler is to make one in CAS. If you encounter a premade or townie toddler Sim who is attractive, it's because they were created in CAS.