From the error message, you did not install AzureAD powershell module in your function app. And if you want to create a dynamic group, you need to use the -MembershipRule parameter, it is just available in the preview version i.e. AzureADPreview module. Though the doc looks like the parameter is available in AzureAD, but per my test, it is not available.

Actually it is easy to solve the issue, but if you want to create a dynamic group with New-AzureADMSGroup, there will be a few follow-up issues, you could follow the steps below.
1.Navigate to the function app in the portal -> Identity -> enable the system-assigned identity(MSI) for your app.
2.Navigate to App files -> host.json -> make sure the managedDependency is Enabled.
{
"version": "2.0",
"managedDependency": {
"Enabled": true
},
"extensionBundle": {
"id": "Microsoft.Azure.Functions.ExtensionBundle",
"version": "[1.*, 2.0.0)"
}
}
In the requirements.psd1, add the AzureADPreview like below, then it will install the AzureADPreview module for you automatically.
@{
'Az' = '5.*'
'AzureADPreview' = '2.0.2.129'
}
In the profile.ps1, remove all the things and add the lines below, this is used to solve the issue related to AzureAD powershell in function, without it, you will get an error, details here.
$64bitPowerShellPath = Get-ChildItem -Path $Env:Windir\WinSxS -Filter PowerShell.exe -Recurse -ErrorAction SilentlyContinue | Where-Object {$_.FullName -match "amd64"}
$env:64bitPowerShellPath=$64bitPowerShellPath.VersionInfo.FileName
3.If you want to use New-AzureADMSGroup to create group in Azure AD, you need the permission in Microsoft Graph, in this case, we use MSI to auth, so use the commands below to give the permission to your MSI.
Run the commands below in local with the Global admin user account, replace <functionapp-name>:
Connect-AzureAD
$MSI = (Get-AzureADServicePrincipal -Filter "displayName eq '<functionapp-name>'")
$MSGraphAppId = "00000003-0000-0000-c000-000000000000"
$GraphServicePrincipal = Get-AzureADServicePrincipal -Filter "appId eq '$MSGraphAppId'"
$PermissionName = "Group.ReadWrite.All"
$AppRole = $GraphServicePrincipal.AppRoles | Where-Object {$_.Value -eq $PermissionName -and $_.AllowedMemberTypes -contains "Application"}
New-AzureADServiceAppRoleAssignment -ObjectId $MSI.ObjectId -PrincipalId $MSI.ObjectId -ResourceId $GraphServicePrincipal.ObjectId -Id $AppRole.Id
4.After step 2, navigate to the kudu(in the Advanced Tools blade of the function app) -> data -> ManagedDependencies -> click the file with the format like 201208083153165.r(choose the newest one via the Modified time) -> check if the AzureADPreview module was installed successfully like below.



5.After the module was installed, in your function code, use the lines below, in my sample, I use this sample to test directly, you could change the code depends on your requirements, remember to replace 201208083153165.r with yours in step 4, it works fine on my side.
using namespace System.Net
# Input bindings are passed in via param block.
param($Request, $TriggerMetadata)
# Write to the Azure Functions log stream.
Write-Host "PowerShell HTTP trigger function processed a request."
# Interact with query parameters or the body of the request.
$name = $Request.Query.Name
if (-not $name) {
$name = $Request.Body.Name
}
$body = "This HTTP triggered function executed successfully. Pass a name in the query string or in the request body for a personalized response."
if ($name) {
$body = "Hello, $name. This HTTP triggered function executed successfully."
}
$script = {
if ($env:MSI_SECRET) {
Disable-AzContextAutosave -Scope Process | Out-Null
Connect-AzAccount -Identity
}
$context = Get-AzContext
$graphtoken = (Get-AzAccessToken -ResourceUrl "https://graph.microsoft.com").Token
$aadtoken = (Get-AzAccessToken -ResourceUrl "https://graph.windows.net").Token
Import-Module D:\home\data\ManagedDependencies\201208083153165.r\AzureADPreview
Connect-AzureAD -AccountId $context.Account -TenantId $context.Tenant -MsAccessToken $graphtoken -AadAccessToken $aadtoken
New-AzureADMSGroup -DisplayName "joyd1" -Description "Dynamic group created from PS" -MailEnabled $False -MailNickName "group" -SecurityEnabled $True -GroupTypes "DynamicMembership" -MembershipRule "(user.department -contains ""Marketing"")" -MembershipRuleProcessingState "On"
}
&$env:64bitPowerShellPath -WindowStyle Hidden -NonInteractive -Command $Script
# Associate values to output bindings by calling 'Push-OutputBinding'.
Push-OutputBinding -Name Response -Value ([HttpResponseContext]@{
StatusCode = [HttpStatusCode]::OK
Body = $body
})

Check the group in the portal:
