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I guess it only reduces the detection range or something, but if you get too close they'll still see you.
If you want to avoid detection at all, just use the Marcher's Set, you can get one in the castle, its on a chest, you can also buy it from the one of the merchants i believe.
Also I did test it and it does seem to work somewhat. Even against enemies it doesn't make you completely invisible though, it does the same for the guards as it does for enemies and reduces the detection range.