What Plystire said. By changing the alpha settings of an entity, you can make it appear more transparent, or less transparent, giving the impression of the entity/character fading. Read the part of the FPSC manual of FPI scripting, it explains most of the commands, including the alpha ones.
This way, you can set certain conditions/pre-requisites for a certain amount of character fade. For example, if the condition is plrdist > 60 then the action would be to make the character less transparent/more visible. And if plrdist <30 then you can set the action to change the alphafade to make the character entity more transparent/less visible.
Those are just examples, of course, I'm not saying that you HAVE to stick with using conditions to determine how close the player is. Either way, good luck. Hopefully this helped explain things a bit better.
Tom