The airflow into the engine compartment is provided by the grille on top.
That opening is big enough for your carburetors to pull air through it AND for your engine's fan to do its job. The fiberglass under the grille should only be closed in at the top and bottom; the sides should be open to allow that air to get in.
The fiberglass also keeps rain off of your alternator or generator, whichever your car has.
The fresh air to the fan comes from that opening. The fan is the conduit for that air to cool the engine; the air goes through the fan hole, then is contained within the shroud on its way out the bottom of the engine compartment.
The engine itself doesn't actually live in the engine compartment. It lives right below it. That air, forced over the vanes on the cylinders by the fan, coming from the engine compartment, then comes out the bottom side as hot air.
Hot air wants to rise ... right back into the engine compartment. When people say they want to seal that compartment off, they want to minimize the air gaps the hot air from below can use to seep back into the "cool" side of the tins, thereby increasing the cooling efficiency of the fan. The hot air below usually wants to flow out the back of the car while its moving, but while idling it'll really warm things up if it has a way to come back topside.
Making that compartment watertight isn't really the goal, but making sure the flat tins at the bottom -- the pieces of metal which reach from the engine's fan shroud to the edges of the compartment -- don't have any big holes in them is kind of critical to the operation. It prevents the fan from recycling hot air.
Hope that helps.