Yes the real thing displayed "distorted images", ie it wasn't a square pixel display. However PAL only games would have been designed for it, so it would be "distorted" for these games to not show them how they were on real system, at least in my opinion. Even NTSC games weren't square but they were closer than the PAL systems.
Check out the video capture above. See the actual area the sonic display is? It doesn't take up the full height, but it takes up the full width. So if we take just the Sonic content out it has an aspect closer to 16:9 , only when we display the full borders should it have a 4:3 aspect like a real TV.
The reason for PAL being so different is Sega didn't extend the height of the display for PAL users yet PAL TV's have more vertical lines. So basically we get the same image as NTSC users, but when put into PAL TVs with lines that are comparatively smaller than NTSC ones we get less height. PAL is 720x576 for instance and NTSC is 720x480, so there are 176 more lines that are filled with border on the PAL SMS.
If you press F3 it zooms in without borders, however this makes the SMS display almost perfectly 16:9 in PAL mode, just like the real content is displayed.