"Where should I install VMM, on a physical server or inside a VM and then add that same physical server as a managed host?" This is a common question from our customers regarding the placement of VMM.
The answer is that either is a fully supported scenario. In fact, some of our customers want to build a fully virtualized environment, with the only physical machines being hosts. In this scenario, the entire environment can then be managed using one VMM server running on a virtual machine on a host that is being managed by the VMM server.
There are however some very important considerations that should be considered when planning your virtualization environment.
If the above scenario is implemented...
1. You will be unable to migrate the VM that contains System Center Virtual Machine Manager to another host, which will fail for obvious reasons. As for best practices, the VM that contains SCVMM should not be migrated, turned off, paused or save state, etc. Also, Performance Resource Optimization (PRO) should not be enabled for that host group, such that it can automatically migrate the VMM server.
2. Another gotcha would be if the physical host went to a 'Not Responding' state. Then you may not be able to open the admin console locally or remotely.
So while this is a fully supported scenario, it may not be the best choice for your particular environment.