It means the downloaded files don’t always stay on your device if you don’t have enough storage. Some will remain on your device, some won’t.
Think iCloud as an extension of your device storage, not a separate backup system. So you can just add things on and iOS / macOS deals with what stays on your device and what goes on cloud. It’s all dependent on file size, usage frequency, available physical storage on specific devices etc.
Thank you, it's good to know I don't need to worry.
Since using files I have noticed some things that a good QOL update can fix.
1. Swiping to see additional images instead of backing out to the main menu and clicking on the next.
2. Setting images as wallpapers (There is an option for the watch face, so it seems like a strange omission to not have wallpaper)
3. Supporting more file type thumbnails. JPG, for instance, do not have preview thumbnails.
Other than these, it's very slick and I am glad I can just keep in the ecosystem without having to rely on other services.